INCOME TAX

T.D. 8930, page 433.Final regulations under section 41 of the Code relate to thecomputation of the credit for increasing research activitiesand the definition of qualified research. These regulationsprovide guidance concerning the requirements to qualify forthe credit and rules for electing and revoking the election ofthe alternative incremental credit.

Rev. Rul. 2001–5, page 451.LIFO; price indexes; department stores. The November2000 Bureau of Labor Statistics price indexes are acceptedfor use by department stores employing the retail inventoryand last-in, first-out inventory methods for valuing inventoriesfor tax years ended on, or with reference to, November 30,2000.

REG–106542–98, page 473.Proposed regulations relate to an election under section 645of the Code to have certain revocable trusts treated andtaxed as part of an estate. A public hearing is scheduled forFebruary 21, 2001.

Notice 2001–10, page 459.Split-dollar insurance arrangements. This notice clari-fies prior rulings issued by the IRS regarding the taxation ofsplit-dollar arrangements, provides taxpayers with interimguidance on the tax treatment of split-dollar arrangementspending publication of further guidance, and requests tax-

payer comments on the interim guidance and a number ofunresolved issues. Rev. Rul 55–747 revoked. Rev. Ruls.64–328 and 66–110 modified.

Notice 2001–11, page 464.This notice provides additional guidance to financial institu-tions located in U.S. possessions in relation to the section1441 nonresident alien withholding regulations that werepublished as T.D. 8734 (1997-2 C.B. 109) and T.D. 8881(2000–23 I.R.B. 1158). Those regulations will apply to cer-tain payments of income to foreign persons after December31, 2000.

EXEMPT ORGANIZATIONS

Rev. Proc. 2001–15, page 465.This procedure provides a modified and supplemented list ofIndian tribal governments that are to be treated similarly tostates for specified purposes under the Internal RevenueCode. Rev. Procs. 83–87 and 92–19 superseded.

ESTATE TAX

T.D. 8912, page 452.Final regulations under section 2601 of the Code relate tothe retention of a trust’s exempt status for generation-skip-ping transfer tax purposes in the case of modifications, etc.,to a trust.

Internal Revenue

bbuulllleettiinnBulletin No. 2001–5

January 29, 2001

HIGHLIGHTSOF THIS ISSUEThese synopses are intended only as aids to the reader inidentifying the subject matter covered. They may not berelied upon as authoritative interpretations.

Department of the TreasuryInternal Revenue Service

Actions Relating to Court Decisions is on the page following the Introduction.Finding Lists begin on page ii.Announcements of Disbarments and Suspensions begin on page 482.

January 29, 2001 2001–5 I.R.B.

The Internal Revenue Bulletin is the authoritative instrumentof the Commissioner of Internal Revenue for announcing offi-cial rulings and procedures of the Internal Revenue Serviceand for publishing Treasury Decisions, Executive Orders, TaxConventions, legislation, court decisions, and other items ofgeneral interest. It is published weekly and may be obtainedfrom the Superintendent of Documents on a subscriptionbasis. Bulletin contents are consolidated semiannually intoCumulative Bulletins, which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin all sub-stantive rulings necessary to promote a uniform applicationof the tax laws, including all rulings that supersede, revoke,modify, or amend any of those previously published in theBulletin. All published rulings apply retroactively unless oth-erwise indicated. Procedures relating solely to matters of in-ternal management are not published; however, statementsof internal practices and procedures that affect the rightsand duties of taxpayers are published.

Revenue rulings represent the conclusions of the Service onthe application of the law to the pivotal facts stated in therevenue ruling. In those based on positions taken in rulingsto taxpayers or technical advice to Service field offices,identifying details and information of a confidential natureare deleted to prevent unwarranted invasions of privacy andto comply with statutory requirements.

Rulings and procedures reported in the Bulletin do not havethe force and effect of Treasury Department Regulations,but they may be used as precedents. Unpublished rulingswill not be relied on, used, or cited as precedents by Ser-vice personnel in the disposition of other cases. In applyingpublished rulings and procedures, the effect of subsequentlegislation, regulations, court decisions, rulings, and proce-

dures must be considered, and Service personnel and oth-ers concerned are cautioned against reaching the sameconclusions in other cases unless the facts and circum-stances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based on provisionsof the Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.This part is divided into two subparts as follows: Subpart A,Tax Conventions, and Subpart B, Legislation and RelatedCommittee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.To the extent practicable, pertinent cross references tothese subjects are contained in the other Parts and Sub-parts. Also included in this part are Bank Secrecy Act Ad-ministrative Rulings. Bank Secrecy Act Administrative Rul-ings are issued by the Department of the Treasury’s Officeof the Assistant Secretary (Enforcement).

Part IV.—Items of General Interest.This part includes notices of proposed rulemakings, disbar-ment and suspension lists, and announcements.

The first Bulletin for each month includes a cumulative indexfor the matters published during the preceding months.These monthly indexes are cumulated on a semiannualbasis, and are published in the first Bulletin of the succeed-ing semiannual period, respectively.

The IRS Mission

Provide America’s taxpayers top quality service by help-ing them understand and meet their tax responsibilities

and by applying the tax law with integrity and fairness toall.

Introduction

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

2001–5 I.R.B. January 29, 2001

It is the policy of the Internal RevenueService to announce at an early datewhether it will follow the holdings in cer-tain cases. An Action on Decision is thedocument making such an announcement.An Action on Decision will be issued atthe discretion of the Service only on un-appealed issues decided adverse to thegovernment. Generally, an Action on De-cision is issued where its guidance wouldbe helpful to Service personnel workingwith the same or similar issues. Unlike aTreasury Regulation or a Revenue Ruling,an Action on Decision is not an affirma-tive statement of Service position. It is notintended to serve as public guidance andmay not be cited as precedent.

Actions on Decisions shall be reliedupon within the Service only as conclu-sions applying the law to the facts in theparticular case at the time the Action onDecision was issued. Caution should beexercised in extending the recommenda-tion of the Action on Decision to similarcases where the facts are different. More-over, the recommendation in the Actionon Decision may be superseded by newlegislation, regulations, rulings, cases, orActions on Decisions.

Prior to 1991, the Service published ac-quiescence or nonacquiescence only incertain regular Tax Court opinions. TheService has expanded its acquiescenceprogram to include other civil tax caseswhere guidance is determined to be help-ful. Accordingly, the Service now may ac-quiesce or nonacquiesce in the holdingsof memorandum Tax Court opinions, aswell as those of the United States DistrictCourts, Claims Court, and Circuit Courtsof Appeal. Regardless of the court decid-ing the case, the recommendation of anyAction on Decision will be published inthe Internal Revenue Bulletin.

The recommendation in every Actionon Decision will be summarized as ac-quiescence, acquiescence in result only,or nonacquiescence. Both “acquies-cence” and “acquiescence in result only”mean that the Service accepts the holdingof the court in a case and that the Servicewill follow it in disposing of cases withthe same controlling facts. However, “ac-quiescence” indicates neither approvalnor disapproval of the reasons assignedby the court for its conclusions; whereas,“acquiescence in result only” indicatesdisagreement or concern with some or all

of those reasons. “Nonacquiescence” sig-nifies that, although no further reviewwas sought, the Service does not agreewith the holding of the court and, gener-ally, will not follow the decision in dis-posing of cases involving other taxpay-ers. In reference to an opinion of a circuitcourt of appeals, a “nonacquiescence” in-dicates that the Service will not followthe holding on a nationwide basis. How-ever, the Service will recognize theprecedential impact of the opinion oncases arising within the venue of the de-ciding circuit.

The Actions on Decisions published inthe weekly Internal Revenue Bulletin areconsolidated semiannually and appear inthe first Bulletin for July and the Cumu-lative Bulletin for the first half of theyear. A semiannual consolidation also ap-pears in the first Bulletin for the follow-ing January and in the Cumulative Bul-letin for the last half of the year.

The Commissioner ACQUIESCES inthe following decision:

Security State Bank v. Commissioner,1

214 F.3d 1254 (10th Cir. 2000),aff’g 111 T.C. 210 (1998)

Actions Relating to Decisions of the Tax Court

1 Acquiescence as to whether a cash method bank that makes short-term loans in the ordinary course of its business is subject to accrual of the stated interest on thoseloans under section 1281(a)(2) or, in the alternative, under section 1281(a)(1).

Section 41.—Credit forIncreasing Research Activities

26 CFR 1.41–1: Credit for increasing researchactivities.

T.D. 8930

DEPARTMENT OF THE TREASURYInternal Revenue Service 26 CFR Parts 1 and 602

Credit for Increasing ResearchActivities

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document containsfinal regulations relating to the computa-tion of the credit under section 41(c) andthe definition of qualified research undersection 41(d). These regulations areintended to provide guidance concerningthe requirements necessary to qualify forthe credit for increasing research activi-ties, guidance in computing the credit forincreasing research activities, and rulesfor electing and revoking the election ofthe alternative incremental credit. Theseregulations reflect changes to section 41made by the Tax Reform Act of 1986 (the1986 Act), the Revenue ReconciliationAct of 1989, the Small Business JobProtection Act of 1996, the TaxpayerRelief Act of 1997, the Tax and TradeRelief Extension Act of 1998 (the 1998Act), and the Tax Relief Extension Act of1999 (the 1999 Act). These regulationsalso provide certain technical amend-ments to the existing regulations.

DATES: Effective Dates: These regula-tions are effective January 3, 2001.

Applicability Dates: For dates ofapplicability of these regulations, seeEffective Dates under SUPPLEMEN-TARY INFORMATION. FOR FUR-THER INFORMATION CONTACT:Lisa J. Shuman or Leslie H. Finlow at(202) 622-3120 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information containedin §1.41–8(b) of this final rule have been

reviewed and approved by the Office ofManagement and Budget in accordancewith the Paperwork Reduction Act of1995 (44 U.S.C. 3507) under the number1545–1625. Responses to these collec-tions of information are mandatory.

The reporting burden contained in§1.41–8(b)(2) (relating to the election ofthe alternative incremental credit) isreflected in the burden of Form 6765.

Estimated average annual burden hoursper respondent under §1.41–8(b)(3) (relatingto the revocation of the election to use thealternative incremental credit) is 250 hours.

Comments concerning the accuracy ofthis burden estimate and suggestions forreducing this burden should be sent to theInternal Revenue Service, Attn: IRSReports Clearance Officer, W:CAR:MP:FP:S:O, Washington, DC 20224, andto the Office of Management andBudget, Attn: Desk Officer for theDepartment of the Treasury, Office ofInformation and Regulatory Affairs,Washington, DC 20503.

The collections of information containedin §1.41–4(d) of this final rule have beenreviewed and, pending receipt and evalua-tion of public comments, approved by theOffice of Management and Budget (OMB)under 44 U.S.C. 3507 and assigned controlnumber 1545–1625. This information isrequired to assist in the examination of theresearch credit and to ensure that theresearch credit is properly targeted to serveas an incentive to engage in qualifiedresearch. This information will be used toverify that the amounts treated as qualifiedresearch expenses were paid or incurred foractivities intended to discover informationthat exceeds, expands, or refines the com-mon knowledge of skilled professionals inthe relevant field of science or engineering.This collection of information is requiredto obtain a benefit. The likely recordkeep-ers are businesses or other for-profit insti-tutions.

Estimated total annual recordkeepingburden for §1.41–4(d) is 18,000 hours.The annual estimated burden per respon-dent varies from .5 hours to 2.5 hours,depending on the circumstances, with anestimated average of 1.5 hours.

The estimated number of recordkeepersis 12,000.

Comments on the collection of infor-

mation should be sent to the Office ofManagement and Budget, Attn: DeskOfficer for the Department of theTreasury, Office of Information andRegulatory Affairs, Washington, DC20503, with copies to the InternalRevenue Service, Attn: IRS ReportsClearance Officer, W:CAR:MP:FP:S:O,Washington, DC 20224. Comments onthe collection of information should bereceived by March 4, 2001. Commentsare specifically requested concerning:

Whether the collection of informationis necessary for the proper performance ofthe functions of the Internal RevenueService, including whether the informa-tion will have practical utility;

The accuracy of the estimated burdenassociated with the collection of informa-tion (see below);

How the quality, utility, and clarity ofthe information to be collected may beenhanced;

How the burden of complying with thecollection of information may be mini-mized, including through the application ofautomated collection techniques or otherforms of information technology; and

Estimates of capital or start-up costs andcosts of operation, maintenance, and pur-chase of services to provide information.

An agency may not conduct or sponsor,and a person is not required to respond to,a collection of information unless it dis-plays a valid control number assigned bythe Office of Management and Budget.

Books or records relating to a collec-tion of information must be retained aslong as their contents may become mater-ial in the administration of any internalrevenue law. Generally, tax returns andtax return information are confidential, asrequired by 26 U.S.C. 6103.

Background

On January 2, 1997, the IRS andTreasury published in the FederalRegister (62 F.R. 81) a notice of proposedrulemaking (REG–209494–90, 1997–1C.B. 723) under section 41 describingwhen computer software that is developedby (or for the benefit of) a taxpayer primar-ily for the taxpayer’s internal use can qual-ify for the credit for increasing researchactivities (the 1997 proposed regulations).Comments responding to the 1997 pro-

2001–5 I.R.B. 433 January 29, 2001

Part I. Rulings and Decisions Under the Internal Revenue Code of 1986

January 29, 2001 434 2001–5 I.R.B.

posed regulations were received and a pub-lic hearing was held on May 13, 1997.

On December 2, 1998, the IRS andTreasury published in the Federal Register(63 F.R. 66503) a notice of proposed rule-making (REG–105170–97, 1998–2 C.B.729) under section 41 relating to the creditfor increasing research activities (the 1998proposed regulations). The 1998 proposedregulations propose rules and examplesrelating to (1) the definition of gross receiptsfor purposes of computing the base amountunder section 41(c), (2) the application of theconsistency rule in computing the baseamount, (3) the definition of qualifiedresearch under section 41(d), (4) the applica-tion of the exclusions from the definition ofqualified research, (5) the application of theshrinking-back rule, and (6) the election ofthe alternative incremental credit. The 1998proposed regulations also propose certaintechnical amendments to the existing regula-tions. Comments responding to the 1998proposed regulations were received and apublic hearing was held on April 29, 1999.

In the 1999 Act, Congress extended thecredit for a five-year period. TheConference Report accompanying the1999 Act included the following languageaddressing the proposed regulations:

In extending the researchcredit, the conferees are con-cerned that the definition ofqualified research be adminis-tered in a manner that is con-sistent with the intent Congresshas expressed in enacting andextending the research credit.The conferees urge theSecretary to consider carefullythe comments he has and mayreceive regarding the proposedregulations relating to the com-putation of the credit undersection 41(c) and the definitionof qualified research under sec-tion 41(d), particularly regard-ing the “common knowledge”standard. The conferees fur-ther note the rapid pace oftechnological advance, espe-cially in service-related indus-tries, and urge the Secretary toconsider carefully the com-ments he has and may receivein promulgating regulations inconnection with what consti-tutes “internal use” with regard

to software expenditures. Theconferees also wish to observethat software research, that oth-erwise satisfies the require-ments of section 41, which isundertaken to support the pro-vision of a service, should notbe deemed “internal use” sole-ly because the business com-ponent involves the provisionof a service.

The conferees wish to reaf-firm that qualified research isresearch undertaken for thepurpose of discovering newinformation which is techno-logical in nature. For purposesof applying this definition, newinformation is information thatis new to the taxpayer, is notfreely available to the generalpublic, and otherwise satisfiesthe requirements of section 41.Employing existing technolo-gies in a particular field or rely-ing on existing principles ofengineering or science is quali-fied research, if such activitiesare otherwise undertaken forpurposes of discovering infor-mation and satisfy the otherrequirements of section 41.

The conferees also are con-cerned about unnecessary andcostly taxpayer record keepingburdens and reaffirm that eligi-bility for the credit is notintended to be contingent onmeeting unreasonable recordkeeping requirements.

H.R. Conf. Rep. No. 106–478, at 132(1999).

After considering the commentsreceived, the statements made at the pub-lic hearings, and the legislative history forthe research credit, the proposed regula-tions are adopted as revised by thisTreasury decision.

Explanation of Provisions

This document amends 26 CFR part 1to provide additional rules under section41. Section 41 contains the rules for thecredit for increasing research activities.

I. Basic Principles

A number of commentators objectedto the inclusion of the basic principles

statement in §1.41–1(a) of the proposedregulations. They stated that the inclu-sion of a basic principles section wasunusual, and that the basic principlessection could be read to impose addi-tional and unwarranted conditions forcredit eligibility. In response to thesecomments, and because IRS andTreasury have concluded that the requi-site principles are adequately reflectedin the provisions of the regulations, thefinal regulations omit a separate state-ment of basic principles. The clarifica-tions that the credit may be availablewhere the technological advance soughtis evolutionary, where the taxpayer isnot the first to achieve the advance, andwhere the taxpayer fails to achieve theintended advance have been incorporat-ed elsewhere in the regulations.

II. Gross Receipts

When Congress revised the computa-tion of the research credit to incorporate ataxpayer’s gross receipts, neither thestatute nor the legislative history definedthe term gross receipts, other than to pro-vide that gross receipts for any taxableyear are reduced by returns andallowances made during the tax year, and,in the case of a foreign corporation, thatonly gross receipts effectively connectedwith the conduct of a trade or businesswithin the United States are taken intoaccount. See section 41(c)(6).

The proposed regulations generallydefined gross receipts as the total amountderived by a taxpayer from all activitiesand sources. However, in recognition ofthe fact that certain extraordinary grossreceipts might not be taken into accountwhen a business determines its researchbudget, the proposed regulations providedthat certain extraordinary items (such asreceipts from the sale or exchange of cap-ital assets) would be excluded from thecomputation of gross receipts.

Several commentators objected to thedefinition of gross receipts in the pro-posed regulations. Referring to theinclusion in a House Budget Report ofthe term sales growth as an apparentshort-hand reference to an increase ingross receipts, some commentatorsargued that gross receipts should be lim-ited to income from sales. See H.R. Rep.No. 101–247, at 1200 (1989). In deter-mining its research budget, however, a

business may take into account anyexpected income stream, regardless ofwhether or not the income is derivedfrom sales or from other active businessactivities. Moreover, many businessesdo not generate any income in the formof sales. Accordingly, the final regula-tions do not adopt this suggestion.

The final regulations also do not adoptsuggestions that the definition of grossreceipts be narrowed to exclude thoseitems not directly related to the conduct ofthe taxpayer’s trade or business. As notedabove, any expected income stream maybe taken into account in determining abusiness’ research budget, regardless ofthe source of the income. Moreover, IRSand Treasury believe that a subjective nar-rowing of the term gross receipts, as sug-gested by these commentators, couldleave the definition of the term, and thusthe computation of the base amount, vul-nerable to manipulation.

For example, a narrower definitionallowing taxpayers to exclude items notderived in the ordinary course of businessmight prompt a taxpayer to assert that cer-tain royalties received in the 1980s werederived in the ordinary course of businessand are includible as gross receipts (thusdecreasing the taxpayer’s fixed-base per-centage), but that certain interest incomereceived in the years preceding the credityear was not derived in the ordinarycourse of business and was not includiblein gross receipts (thus decreasing the baseamount). Nor would a rule of consistencybe effective in preventing such manipula-tion. While the taxpayer described abovewould be characterizing the nature of itsincome items as derived or not derived inthe ordinary course of a trade or businessso as to maximize the amount of the cred-it, the taxpayer would not be taking incon-sistent positions with respect to the sameitems of income.

Several commentators objected to thedefinition of gross receipts in the pro-posed regulations as it applies to start-upfirms with pre-operating interest income.If pre-operating interest income is treatedas a gross receipt, many start-up firmswould be precluded from using the start-up rules to compute their fixed-base per-centages, because the application of thestart-up rules is conditioned on a taxpayernot having both gross receipts and quali-fied research expenses in certain taxable

years during the 1980s. Moreover,because a start-up firm whose only grossreceipt is pre-operating interest incomelikely would have significant qualifiedresearch expenses relative to grossreceipts (and thus a high fixed-base per-centage), such a firm likely would deriveless benefit from the credit.

IRS and Treasury recognize that thestart-up rules appear to contemplate thatthere will be years in which a taxpayer hasqualified research expenses but no grossreceipts. However, it would be difficult toconceive of such a year if gross receipts aredefined to include pre-operating investmentincome. To address these concerns and pur-suant to the regulatory authority of section41(c)(3)(B)(iii), the final regulationsexclude from the definition of gross receiptsany income received by a taxpayer in a tax-able year that precedes the first taxable yearin which the taxpayer derives more than$25,000 in gross receipts other than invest-ment income. For this purpose, investmentincome is defined as interest or distributionswith respect to stock (other than the stock ofa 20-percent owned corporation as definedin section 243(c)(2) of the Code).

Some commentators suggested that thedefinition of gross receipts should be clar-ified to exclude certain payments made bypharmaceutical manufacturers to variousinsurers, managed care organizations andstate governments. The final regulationsdo not adopt any provision specificallyaddressing such payments.

III. The Discovery Requirement

To qualify for the research credit, sec-tion 41(d) requires that a taxpayer under-take research for the purpose of discover-ing information which is technological innature, and the application of which isintended to be useful in the developmentof a new or improved business componentof the taxpayer. Section 1.41–4(a)(3) ofthe proposed regulations defines thephrase discovering information as obtain-ing knowledge that exceeds, expands, orrefines the common knowledge of skilledprofessionals in a particular field of sci-ence or engineering.

Commentators criticized this definitionof discovering information, arguing thatthe definition imposes a discovery require-ment that was not mandated by the statute.Commentators suggested that the phrasediscovering information, as used in the

statute, was not intended as an additionalrequirement, but was simply used as aphrase to link the term research with thetypes of information required as the subjectof the research. Commentators argued thata taxpayer who seeks to resolve its ownsubjective uncertainty as to the informationat issue is undertaking sufficient discoveryfor purposes of section 41(d).

Consistent with the legislative historyand case law as described below, however,IRS and Treasury continue to believe thatsection 41 conditions credit eligibility onan attempt to discover information thatgoes beyond the common knowledge ofskilled professionals in the particular fieldof science or engineering.

The legislative history to the 1986 Act,which narrowed the definition of the termqualified research, explained that Congresshad originally enacted the research credit toencourage business firms to perform theresearch necessary to increase the innova-tive qualities and efficiency of the U.S.economy. H.R. Rep. No. 99–426, at177–78; S. Rep. No. 99–313, at 694–95.Congress was concerned that taxpayers hadapplied the original definition of qualifiedresearch “too broadly,” that some taxpayershad claimed the credit for “virtually anyexpenses relating to product development”and that many of these taxpayers were “inindustries that do not involve high technol-ogy or its application in developing techno-logically new and improved products ormethods of production.” Id. In an illustra-tion of the changes enacted, the legislativehistory explained that, under the new defin-ition: “Research does not rely on the prin-ciples of computer science merely becausea computer is employed. Research may betreated as undertaken to discover informa-tion that is technological in nature, howev-er, if the research is intended to expand orrefine existing principles of computer sci-ence.” H.R. Conf. Rep. No. 99–841, atII–71 n.3 (1986) (emphasis added).

Following the 1986 Act changes to thecredit, a discovery requirement has beenapplied in several recent cases. See, e.g.,United Stationers, Inc. v. United States,163 F.3d 440 (7th Cir. 1998), Norwest v.Commissioner, 110 T.C. 454 (1998), andWICOR, Inc. v. United States, 116 F.Supp. 2d 1028 (E.D. Wis. 2000).

In reaffirming the scope of the termqualified research, the Conference Reportto the 1998 Act noted that:

2001–5 I.R.B. 435 January 29, 2001

evolutionary research activi-ties intended to improve func-tionality, performance, relia-bility, or quality are eligiblefor the credit, as are researchactivities intended to achievea result that has already beenachieved by other persons butis not yet within the commonknowledge (e.g., freely avail-able to the general public) ofthe field (provided that theresearch otherwise meets therequirements of section 41,including not being excludedby subsection (d)(4)).

H.R. Conf. Rep. No. 105–825, at 1548(1998) (emphasis added). In particular, itis noteworthy that the conferees clarifiedthat the credit is available for researchintended to achieve a result that has beenachieved by others but is not yet withinthe common knowledge. The negativeinference is that the credit is not availablefor research intended to achieve a resultthat has been achieved by others and iswithin the common knowledge of thefield.

The discovery requirement as set forthin the final regulations also is consistentwith the legislative history to the 1999 Act(the text of which is set forth above underBackground). In that legislative history,for example, the conferees stated that:

[e]mploying existing tech-nologies in a particular fieldor relying on existing princi-ples of engineering or scienceis qualified research, if suchactivities are otherwise under-taken for purposes of discov-ering information and satisfythe other requirements undersection 41.

H.R. Conf. Rep. No. 106–478, at 132(emphasis added). By referring separate-ly to a requirement that the research beundertaken for purposes of discoveringinformation, this legislative history againconfirmed that the phrase “discoveringinformation” is a separate substantiverequirement and not merely a phrase usedto link the term research with the types ofinformation required as the subject of theresearch.

In light of the case law and the legisla-tive history, the final regulations retain therequirement that a taxpayer seek to dis-

cover information that exceeds, expands,or refines the common knowledge ofskilled professionals in the particular fieldof science or engineering. However, con-sistent with the legislative history to the1999 Act, IRS and Treasury have careful-ly considered comments relating to the“common knowledge” standard, andmade a number of changes to address spe-cific taxpayer concerns about the discov-ery requirement.

In response to comments regarding theapplication of the discovery requirement,the final regulations clarify that the phrase“common knowledge of skilled profes-sionals in a particular field of science orengineering” means information thatshould be known to skilled professionalshad they performed, before the research inquestion was undertaken, a reasonableinvestigation of the existing level of infor-mation in the particular field of science orengineering. Thus, in order to satisfy thediscovery requirement, research must beundertaken for the purpose of discoveringinformation that is beyond the knowledgethat should be known to skilled profes-sionals had they performed a reasonableinvestigation of the existing level ofknowledge in the particular field of sci-ence or engineering. There is no require-ment, however, that a taxpayer actuallyconduct such an investigation in order toclaim the credit. To further clarify theapplication of the discovery requirement,the final regulations also state, as anexample, that trade secrets generally arenot within the common knowledge ofskilled professionals because they are notreasonably available to skilled profession-als not employed, hired, or licensed by theowner of such trade secrets.

Also, in response to comments, the dis-covery requirement in the final regula-tions has been reworded to refer to thecommon knowledge of skilled profession-als in a particular field of science or engi-neering (rather than a particular field oftechnology or science, as in the proposedregulations). As in the proposed regula-tions, the common knowledge of skilledprofessionals is intended to serve as anobjective standard for the baseline knowl-edge that a credit-eligible taxpayer mustseek to exceed, expand, or refine. The ref-erence to the common knowledge ofskilled professionals is not intended toimpose qualification requirements on the

personnel that the taxpayer uses to con-duct qualified research.

Several commentators raised concernsthat the discovery requirement in the pro-posed regulations required that taxpayersmust “prove a negative;” in response tothese concerns about the potential burdenimposed on taxpayers to demonstrate thatthey satisfy the discovery requirement,IRS and Treasury have added to the finalregulations a rebuttable presumption. Thefinal regulations provide that, if a taxpay-er demonstrates with credible evidencethat research activities were undertaken toobtain the information described in docu-mentation prepared before or during theearly stages of the research and if thatdocumentation also sets forth the basis forthe taxpayer’s belief that obtaining thisinformation would exceed, expand, orrefine the common knowledge of skilledprofessionals in the particular field of sci-ence or engineering, then the researchactivities are presumed to satisfy the dis-covery requirement. This rebuttable pre-sumption would arise, however, only ifthe taxpayer cooperates with reasonablerequests by the IRS for witnesses, infor-mation, documents, meetings, and inter-views.

In a case where the rebuttable presump-tion arises, the final regulations providethat the Commissioner may overcome thispresumption by demonstrating that theinformation described in the taxpayer’sdocumentation was within the commonknowledge of skilled professionals in theparticular field of science or engineering.That is, the Commissioner would have todemonstrate that the information wouldhave been known to such skilled profes-sionals had they performed (before theresearch was undertaken) a reasonableinvestigation of the existing level of infor-mation in the particular field of science orengineering.

By way of further clarification, a provi-sion has been added and several exampleshave been changed or eliminated toremove any implication that the underly-ing principles of science or engineeringused in the research must themselves benovel. IRS and Treasury recognize thatvirtually all research utilizes existing sci-entific principles and technology. Therequirement that a taxpayer seek toexceed, expand, or refine the commonknowledge of skilled professionals does

January 29, 2001 436 2001–5 I.R.B.

not mean that the tools and principlesused in the attempt to achieve the techno-logical advance must themselves bebeyond the common knowledge.

Also, in response to commentators’suggestions, the final regulations providethat a taxpayer is conclusively presumedto have obtained knowledge that exceeds,expands, or refines the common knowl-edge of skilled professionals in the rele-vant field of science or engineering, if thattaxpayer was awarded a patent for thebusiness component. Section 101 of title35 of the United States Code provides that“[w]hoever invents or discovers any newand useful process, machine, manufac-ture, or composition of matter, or any newand useful improvement thereof, mayobtain a patent therefor, subject to theconditions and requirements of [title 35].”Such an invention or discovery may bepatentable if it was not previously known,used, patented, or described, as set forth in35 U.S.C. 102, and the differencesbetween the invention and the prior art aresuch that the invention would not havebeen obvious to a person having ordinaryskill in the relevant art. See 35 U.S.C.102.

The final regulations contain a patentsafe harbor because IRS and Treasurybelieve that information leading to apatentable invention constitutes informa-tion that exceeds, expands, or refines thecommon knowledge of skilled profession-als in the relevant field. Of course, quali-fication under the patent safe harbor doesnot necessarily establish that the discov-ery requirement is satisfied with respect toall of the research associated with thepatentable invention (for example, someof the research might relate to style).

The final regulations emphasize that apatent is not a precondition for credit eli-gibility. Because not all research suc-ceeds in achieving its objective and forother reasons, it is obvious that not allresearch intended to discover informationthat goes beyond the common knowledgeresults in a patent. Thus, the absence of apatent should have no bearing on crediteligibility. The factors underlying thedenial of a patent application, on the otherhand, may be relevant to the determina-tion of whether the discovery requirementis satisfied.

Because section 41(d)(3)(B) providesthat the credit is not available for research

related to style, taste, cosmetic, or season-al design factors, the patent safe harbordoes not include patents for design, asdefined by 35 U.S.C. 171.

In light of these changes, modificationshave been made to several examples in theproposed regulations, including an exam-ple in the proposed regulations relating toresearch undertaken to develop a new tire.This example has been moved to the sec-tion of the final regulations that illustratesthe exclusion for research conducted afterthe beginning of commercial production(discussed in VII. Research AfterCommercial Production of this Preamble).

To address concerns expressed by anumber of commentators that the commonknowledge standard may be difficult fortaxpayers and examiners to apply, and maygive rise in practice to inconsistent treat-ment of similarly situated taxpayers (espe-cially where examiners have limitedexpertise in a particular scientific field)IRS and Treasury have initiated measuresto promote fair and consistent applicationof the discovery requirement and the otherconditions for credit eligibility. Consistentwith the suggestion of one commentator,IRS has met with Revenue Canada to dis-cuss Canada’s joint industry/governmentinitiative to improve administration of theCanadian research credit. IRS also hasmet with various industry associations toform joint initiatives to devise guidelinesfor the administration and examination ofthe credit in particular industries. Similarefforts with respect to other industrygroups are anticipated.

IV. Process of Experimentation

Commentators objected to §1.41–4(a)(5)of the proposed regulations, which defines aprocess of experimentation to include a pre-scribed four-step process. Commentatorsargued that while the four-step process mayaccurately have described the pure scientif-ic method of conducting experiments, com-mercial and industrial practice does notalways conform precisely to such require-ments. Commentators also argued that thefour-step process required by the proposedregulations was adapted from a descriptionin the legislative history of the 1986 Act thatwas included for illustrative purposes andnot as a comprehensive definition of theterm process of experimentation.

In light of these comments, the finalregulations provide that taxpayers con-

ducting a process of experimentation may,but are not required to, engage in the four-step process.

Consistent with the legislative history,the final regulations provide further clari-fication on the manner in which a processof experimentation differs from researchand development in the experimental orlaboratory sense, as required by§1.174–2(a). A process of experimenta-tion is a process to evaluate more than onealternative designed to achieve a resultwhere the capability or method of achiev-ing that result is uncertain at the outset,but (in contrast to expenditures that quali-fy under section 174) does not include theevaluation of alternatives to establish theappropriate design of a business compo-nent when the capability and method fordeveloping or improving the businesscomponent are not uncertain. See H.R.Conf. Rep. No. 99–841, at II–72 (“Theterm process of experimentation means aprocess involving the evaluation of morethan one alternative designed to achieve aresult where the means of achieving thatresult is uncertain at the outset.”); UnitedStationers, 163 F.3d at 446; Norwest, 110T.C. at 496.

V. Recordkeeping Requirement

Part of the four-step process of experi-mentation test prescribed in §1.41–4(a)(5)of the proposed regulations was a require-ment that taxpayers record the results oftheir experiments. Maintaining that thisrequirement was particularly burdensome,commentators argued that, in the industri-al or commercial setting, the recording ofresults is not necessarily inherent in abona fide process of experimentation.

For these reasons, the final regulationsdo not contain a requirement that taxpay-ers record the results of their experiments.Moreover, reference to the recording ofresults has been eliminated from the illus-trative (non-mandatory) description of afour-step process of experimentation.

To assist in the examination of claimsfor the credit and to ensure that the creditis properly targeted to serve as an incen-tive to engage in qualified research, thefinal regulations do include a less burden-some contemporaneous documentationrequirement. Under the final regulations,taxpayers must prepare and retain writtendocumentation before or during the earlystages of the research project that

2001–5 I.R.B. 437 January 29, 2001

January 29, 2001 438 2001–5 I.R.B.

describes the principal questions to beanswered and the information the taxpay-er seeks to obtain that exceeds, expands,or refines the common knowledge ofskilled professionals in the relevant fieldof science or engineering. Taxpayers alsomust comply with the general recordkeep-ing requirements of section 6001.

As noted above, taxpayers may alsoavail themselves of a rebuttable presump-tion that they satisfy the discoveryrequirement if their contemporaneousdocumentation also sets forth the basis forthe taxpayer’s belief that obtaining thisinformation would exceed, expand, orrefine the common knowledge of skilledprofessionals in the particular field of sci-ence or engineering.

VI. The Shrinking-back Rule

Under §1.41–4(b) of the proposed regu-lations, and consistent with the legislativehistory to the 1986 Act, if the requirementsof section 41(d) are not met for an entireproduct, then the credit may be availablewith respect to the next most significantsubset of elements of that product. Thisshrinking back continues until either a sub-set of elements of the product that satisfiesthe requirements is reached, or the mostbasic element of the product is reached andsuch element fails to satisfy the test.

The final regulations clarify that thisshrinking-back rule applies only if the tax-payer incurs some research expenses withrespect to the overall business componentthat would constitute qualified researchexpenses with respect to that business com-ponent but for the fact that less than sub-stantially all of the research activities withrespect to that component constitute ele-ments of a process of experimentation thatrelates to a new or improved function, per-formance, reliability or quality. In caseswhere the substantially-all test is satisfiedwith respect to the overall business compo-nent, those research expenses with respectto the overall business component that arequalified research expenses are credit eligi-ble, and there is no need for a taxpayer toshrink back to apply the tests with respectto subsets of elements of the business com-ponent. Of course, the mere fact that tax-payers are not required to shrink back to asmaller business component does not meanthat all of the research expenses withrespect to the overall credit are credit eligi-ble. Research expenses that are not quali-

fied research expenses, for examplebecause they relate to style, taste, cosmetic,or seasonal design factors, remain ineligiblefor the credit.

In response to commentators’ sugges-tions, the final regulations also clarify that,if the original product is not eligible for thecredit, the application of the shrinking-backrule may result in credit eligibility for mul-tiple business components that are subsetsof the original product. The regulationsclarify that the shrinking-back rule may notitself be applied as a reason to excluderesearch activities from credit eligibility.Finally, an example has been added to illus-trate these concepts.

VII. Research After CommercialProduction

Several commentators addressed the sec-tion of the proposed regulations providingthat activities conducted after the beginningof commercial production of a businesscomponent are not qualified research.Under the proposed regulations, activitiesare conducted after the beginning of com-mercial production of a business compo-nent if such activities are conducted afterthe component is developed to the pointwhere it is ready for commercial sale oruse, or meets the basic functional and eco-nomic requirements of the taxpayer for thecomponent’s sale or use. Moreover, certainspecified activities (like preproductionplanning for a finished business componentand trial production runs) are deemed tooccur after the beginning of commercialproduction.

Because the provisions set forth aboveclosely reflect the legislative history of thepost-production exclusion, these tests havebeen retained in the final regulations. SeeH.R. Conf. Rep. No. 841, at II–74–75.However, several changes have been madein response to commentators’ concerns.

First, a change has been made to the listof activities that are per se deemed to occurafter the beginning of commercial produc-tion. In the proposed regulations, one of theitems on that list was “debugging or cor-recting flaws in a business component.”Consistent with the legislative history, IRSand Treasury continue to believe thatdebugging should be conclusively pre-sumed to occur after the beginning of com-mercial production. However, many activi-ties conducted before the beginning ofcommercial production could be construed

as the correction of flaws. Thus, the per selist contained in the final regulations hasbeen changed to refer to debugging activi-ties but not to the correction of flaws.

Second, an example has been added toclarify that a new research project toimprove a business component is not dis-qualified merely because the new researchproject commences after the commercialproduction of the unimproved businesscomponent. Other examples have beenchanged to eliminate references to and fac-tual assertions about specific industries.

Third, the final regulations incorporateprovisions from the legislative history to the1986 Act that clinical testing of a pharma-ceutical product prior to its commercialproduction in the United States is not treat-ed as occurring after the beginning of com-mercial production even if the product iscommercially available in other countries,and that additional clinical testing of a phar-maceutical product after a product has beenapproved for a specific therapeutic use bythe Food and Drug Administration and isready for commercial production and saleare not treated as occurring after the begin-ning of commercial production if such clin-ical tests are undertaken to establish newfunctional uses, characteristics, indications,combinations, dosages, or delivery formsfor the product.

VIII. Adaptation

Several commentators suggested alter-nate formulations of the adaptation exclu-sion. Because such formulations effective-ly would render the adaptation exclusioninapplicable to activities that satisfy theother requirements for qualified research,thereby reading the exclusion out of theInternal Revenue Code, the final regula-tions do not adopt the suggestions.

Two new examples clarify that the adap-tation exclusion may also apply to contractresearch expenses paid by the customer tothe vendor or to in-house research expensesincurred by the customer itself to adapt anexisting business component to that cus-tomer’s requirement or need.

IX. Internal-use Software

As noted above, the 1997 proposed regu-lations describe when software that isdeveloped by (or for the benefit of) a tax-payer primarily for the taxpayer’s internaluse can qualify for the credit. The final reg-ulations incorporate these special provi-

2001–5 I.R.B. 439 January 29, 2001

sions for internal-use software. A numberof changes have been made to the 1997proposed regulations to address commenta-tor concerns, and to coordinate the internal-use provisions with the other provisions ofthe final regulations.

Under the proposed regulations, researchwith respect to software developed primar-ily for a taxpayer’s internal use is qualifiedresearch only if it satisfies both the generalrequirements for credit eligibility undersection 41 and an additional condition foreligibility. Except for certain softwaredeveloped for use in conducting qualifiedresearch or for use in a production process,and for certain software created as part of apackage of hardware and software devel-oped concurrently, the additional conditionfor eligibility is a requirement that the tax-payer satisfy a three-part test (requiring thatthe internal-use software be innovative, thatits development involve significant eco-nomic risk, and that it not be commerciallyavailable).

Most of the comments received focusedon two issues — (1) the determination ofwhen software is developed primarily forinternal use, and (2) the application of thethree-part test to internal-use software. Onthe first issue, several commentators urgedthat internal-use software be defined toexclude any software used to deliver a ser-vice to customers or any software thatincludes an interface with customers or thepublic. After careful analysis of the leg-islative history to the 1986 Act and the1999 Act, however, IRS and Treasury con-cluded that such a broad exclusion wouldbe inconsistent with the statutory mandate,because the exclusion would extend tosome software that Congress clearlyintended to treat as internal-use software.At the same time, IRS and Treasury sharethe commentators’ belief that the goals ofthe research credit may be advanced byremoving additional conditions for credit-eligibility in the case of certain internal-usesoftware used to provide new features toservices offered to customers that are nototherwise available to them. Accordingly,as described in more detail below, the finalregulations retain the definition of internal-use software contained in the proposed reg-ulations, but provide a new exception (pur-suant to the regulatory authority undersection 41(d)(4)(E)) under which the devel-opment of certain internal-use softwareused to deliver noncomputer services to

customers with features that are not yetoffered by a taxpayer’s competitors is notsubject to the three-part test.

Consistent with a statement in theConference Report to the 1999 Act thatsoftware research undertaken to support theprovision of a service should not bedeemed internal-use software “solelybecause the business component involvesthe provision of a service,” the final regula-tions clarify that the determination ofwhether software is internal-use softwaredepends on the nature of the service pro-vided by the taxpayer. Software that isintended to be used to provide noncomput-er services to customers is internal-use soft-ware, while software that is to be used toprovide computer services is not developedprimarily for internal use. Computer ser-vices are services offered by a taxpayer tocustomers who do business with the tax-payer primarily for the use of the taxpayer’scomputer or software technology.Noncomputer services are services offeredby a taxpayer to customers who do businesswith the taxpayer primarily to obtain a ser-vice other than a computer service, even ifsuch other service is enabled, supported, orfacilitated by computer or software tech-nology.

The conclusion that software used toprovide noncomputer services is internal-use software is consistent with the legisla-tive history to the 1986 Act, which definedinternal-use software as software used ingeneral administrative functions and soft-ware used in providing noncomputer ser-vices (such as accounting, consulting, orbanking services). See H.R. Conf. Rep.No. 841, at II–73 (emphasis added).

As noted above, the final regulationscontain a new exception under which a tax-payer is not required to establish that inter-nal-use software used to provide noncom-puter services containing features orimprovements that are not yet offered by ataxpayer’s competitors satisfies the three-part test. Software that is intended to beused to provide noncomputer services isdescribed within the exception if the soft-ware is designed to provide customers anew feature with respect to a noncomputerservice; the taxpayer reasonably anticipat-ed that customers would choose to obtainthe noncomputer service from the taxpayer(rather than from the taxpayer’s competi-tors) because of those features of the ser-vice that will be provided by the software;

and those features are not available (at thetime the research is undertaken) from anyof the taxpayer’s competitors.

No inference should be drawn that soft-ware described within the foregoing excep-tion is not internal-use software or thatinternal-use software not described withinthe exception would fail the three-part test.Rather, the exception reflects a determina-tion by IRS and Treasury that it is appro-priate to exercise the regulatory authority insection 41(d)(4)(E) to exempt certain inter-nal-use software from having to fulfil addi-tional conditions for credit eligibility. Thisexercise of regulatory authority is based ona determination that the development ofsoftware containing features or improve-ments that are not available from a taxpay-er’s competitors and that provide a demon-strable competitive advantage is morelikely to increase the innovative qualitiesand efficiency of the U.S. economy (bygenerating knowledge that can be used byother service providers) than is the devel-opment of software used to provide non-computer services containing features orimprovements that are already offered byothers. IRS and Treasury believe thatdrawing such a line is an appropriate way toadminister the credit with a view to identi-fying and facilitating the credit availabilityfor software with the greatest potential forbenefitting the U.S. economy, an importantrationale for the research credit.

The final regulations also make a num-ber of changes with respect to the three-part high threshold of innovation test,which continues to apply to certain soft-ware not described within the new excep-tion. For example, commentators hadquestioned whether the 1997 proposedregulations impose a separate high thresh-old of innovation requirement that servesas an additional condition for credit eligi-bility, even where taxpayers otherwisesatisfy the three-part test. The final regu-lations clarify that the three-part test is thehigh threshold of innovation test, and nota separate requirement. Similarly, com-mentators had objected to a sentence inthe 1997 proposed regulations that couldbe read to suggest that certain internal-usesoftware could never qualify for the cred-it. The final regulations clarify thatresearch with respect to internal-use soft-ware that satisfies both the general condi-tions for credit eligibility and the three-part test is eligible for the credit.

January 29, 2001 440 2001–5 I.R.B.

Consistent with the application of thediscovery requirement, the final regulationsadopt the suggestion of several commenta-tors that the three-part test should beapplied without regard to whether the tax-payer succeeds in achieving the resultsdescribed in that test.

Commentators questioned whether the“as where” clauses used to elaborate on thethree requirements of the high threshold ofinnovation test in the 1997 proposed regula-tions were intended as mandatory require-ments or merely as illustrations of ways inwhich taxpayers could satisfy the tests. Byreplacing the “as where” clauses with “inthat” clauses, the final regulations confirmthat a taxpayer must satisfy the provisions,as elaborated. Consistent with this clarifi-cation, the final regulations provide that theinnovative prong of the three-part test maybe satisfied with respect to any intendedimprovement, not just reductions in cost orimprovements in speed.

Under the final regulations, all qualifiedresearch, including research with respect tointernal-use software, must satisfy the dis-covery requirement (that is, must be intend-ed to exceed, expand, or refine the commonknowledge of skilled professionals in theparticular field of science or engineering).The final regulations clarify how the three-part high threshold of innovation test sup-plements the discovery requirement.Specifically, the final regulations providethat several aspects of the three-part test(the determination of whether the softwareis intended to result in an improvement thatis substantial and economically significantand the extent of uncertainty and technicalrisk) also must be applied with respect tothe common knowledge of skilled profes-sionals. In essence, the common knowl-edge of skilled professionals rather than theknowledge base of the taxpayer’s employ-ees is treated as the baseline with respect towhich the intended software must satisfythe innovative prong and other prongs ofthe three-part test. Stated differently,research with respect to internal-use soft-ware is credit eligible only if it is intendedto exceed, expand, or refine the commonknowledge of skilled professionals (asdefined in §1.41–4(a)(3)(ii)) to a degreethat is substantial and economically signifi-cant. See Norwest 110 T.C. at 499–500(stating that “...the extent of the improve-ments required by Congress with respect tointernal use software is much greater than

that required in other fields” and that “...thesignificant economic risk test requires ahigher threshold of technological advance-ment in the development of internal usesoftware than in other fields”).

Reference to the common knowledge ofskilled professionals as the baseline is nec-essary to give proper meaning to the statu-tory three-part test. For example, if theinnovative requirement was applied simplywith respect to the prior state of the taxpay-er’s own business, then ordinary inventorysoftware installed by a taxpayer who previ-ously tracked its inventory manually couldbe deemed to satisfy the innovative require-ment merely because the taxpayer hadachieved a substantial and economicallysignificant improvement in speed over itsprior non-automated operations.

Although the final regulations related tointernal use software generally are effectivefor taxable years beginning after December31, 1985, the provisions relating to softwaredeveloped for use in providing computerand noncomputer services to customers andthe provisions clarifying the interaction ofthe three-part test with the discoveryrequirement, like other provisions concern-ing the discovery requirement, are effectiveonly prospectively; however, taxpayers mayrely on these rules for expenditures paid orincurred prior to January 3, 2001.

X. Alternative Incremental Credit

Certain commentators suggested thattaxpayers be permitted to elect the alter-native incremental credit on an amendedreturn. However, IRS and Treasurybelieve that the intended incentive effectsof the credit would not be advanced bypermitting taxpayers to make retroactiveelections to alter the computation of (andpresumably increase) the credit for prioryears. Similarly, the availability of aretroactive election would undermine theapplication of section 41(c)(4)(B). Thus,the final regulations retain the require-ment contained in the proposed regula-tions that the election to apply the provi-sions of the alternative incremental creditmust be made on the taxpayer’s timelyfiled original return.

Effective Dates

In general, the regulations are applica-ble for expenditures paid or incurred on orafter January 3, 2001. However, the regu-

lations addressing the base amount areapplicable for taxable years beginning onor after January 3, 2001. The regulationsaddressing internal-use software areapplicable for taxable years beginningafter December 31, 1985. However,§ 1 . 4 1 – 4 ( c ) ( 6 ) ( i i ) ( C ) ( 4 ) ,§1.41–4(c)(6)(iv)(A) and (B),§1.41–4(c)(6)(v), the second and thirdsentences of §1.41–4(c)(6)(vii), and§1.41–4(c)(6)(viii) Example 2 are applic-able for expenditures paid or incurred onor after January 3, 2001. The special doc-umentation requirements of §1.41–4(d)are applicable with respect to researchprojects that begin on or after March 4,2001. The regulations providing for theelection and revocation of the alternativeincremental credit are applicable for tax-able years ending on or after January 3,2001. No inference should be drawn fromthe applicability date concerning theapplication of section 41 to expenditurespaid or incurred or the computation of thebase amount before the applicability date.

Special Analyses

It has been determined that these regu-lations are not a significant regulatoryaction as defined in Executive Order12866. Therefore, a regulatory assess-ment is not required. It also has beendetermined that section 553(b) of theAdministrative Procedure Act (5 U.S.C.chapter 5) does not apply to these regula-tions.

It is hereby certified that the collectionof information contained in these regula-tions will not have a significant economicimpact on a substantial number of smallentities. This certification is based on thefact that the rules of this section impactonly taxpayers who engage in qualifiedresearch. Moreover, in those instanceswhere the rules of this section impact smallentities, the economic impact is not likelyto be significant because it merely requirestaxpayers to (1) prepare (before or duringthe early stages of a research project) andretain written documentation describingthe principal questions to be answered andthe information the taxpayer seeks toobtain that satisfies the requirements of§1.41–4(a)(3) of these regulations; (2) electon Form 6765, “Credit for IncreasingResearch Activities,” to use the alternativeincremental credit if the entity desires touse that method; and (3) obtain permission

2001–5 I.R.B. 441 January 29, 2001

to revoke the alternative incremental creditelection, if so desired. Further, the eco-nomic impact of electing the alternativeincremental credit on Form 6765 alsowould not be significant because the elec-tion is made on the same form and is basedon the same information that is used toclaim the research credit. Accordingly, aregulatory flexibility analysis under theRegulatory Flexibility Act (5 U.S.C. chap-ter 6) is not required.

Pursuant to section 7805(f), the noticeof proposed rulemaking preceding theseregulations was submitted to the ChiefCounsel for Advocacy of the SmallBusiness Administration for comment onits impact on small business.

Drafting Information

The principal authors of these regula-tions are Lisa J. Shuman and Leslie H.Finlow of the Office of the AssociateChief Counsel (Passthroughs and SpecialIndustries), IRS. However, personnelfrom other offices of the IRS and theTreasury Department participated in theirdevelopment.

Adoption of Amendments to theRegulations

Accordingly, 26 CFR parts 1 and 602are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. Revise the undesignated center-

heading immediately before §1.30–1 toread as follows:

CREDITS ALLOWABLE UNDERSECTIONS 30 THROUGH 44B

Par. 3. Remove the undesignated cen-terheading immediately before §1.41–0.

Par. 4. Section 1.41–0 is revised to readas follows:

§1.41–0 Table of contents.

This section lists the paragraphs con-tained in

§§1.41–1 through 1.41–8 as follows:

§1.41–1 Credit for increasing researchactivities.

(a) Amount of credit.

(b) Introduction to regulations under sec-tion 41.

§1.41–2 Qualified research expenses.

(a) Trade or business requirement.(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 partnershipsand joint ventures.(b) Supplies and personal property used inthe 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 taxableyears 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.

§1.41–3 Base amount for taxable yearsbeginning on or after January 3, 2001.

(a) New taxpayers.(b) Special rules for short taxable years.(1) Short credit year.(2) Short taxable year preceding credityear.(3) Short taxable year in determiningfixed-base percentage.(c) Definition of gross receipts.(1) In general. (2) Amounts excluded.(3) Foreign corporations. (d) Consistency requirement.(1) In general.(2) Illustrations. (e) Effective date.

§1.41–4 Qualified research forexpenditures paid or incurred on or afterJanuary 3, 2001.

(a) Qualified research. (1) General rule.(2) Requirements of section 41(d)(1).(3) Undertaken for the purpose of discov-ering information. (i) In general.(ii) Common knowledge.(iii) Means of discovery.(iv) Patent safe harbor.(v) Rebuttable presumption.(4) Technological in nature.(5) Process of experimentation.(6) Substantially all requirement.(7) Use of computers and informationtechnology.(8) Illustrations.(b) Application of requirements for quali-fied 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 tothe business component.(iii) Activities related to productionprocess or technique.(iv) Clinical testing.(3) Adaptation of existing business com-ponents.(4) Duplication of existing business com-ponent.(5) Surveys, studies, research relating tomanagement functions, etc. (6) Internal-use computer software.(i) General rule.(ii) Requirements.(iii) Primarily for internal use. (iv) Software used in the provision of ser-vices.(A) Computer services.(B) Noncomputer services. (v) Exception for certain software used inproviding noncomputer services.(vi) High threshold of innovation test.(vii) Application of high threshold ofinnovation test.(viii) Illustrations.(ix) Effective dates.(7) Activities outside the United States,Puerto Rico, and other possessions.(i) In general. (ii) Apportionment of in-house researchexpenses. (iii) Apportionment of contract researchexpenses.

January 29, 2001 442 2001–5 I.R.B.

(8) Research in the social sciences, etc.(9) Research funded by any grant, con-tract, or otherwise.(10) Illustrations. (d) Documentation.(e) Effective dates.

§1.41–5 Basic research for taxable yearsbeginning after December 31, 1986.[Reserved]

§1.41–6 Aggregation of expenditures.

(a) Controlled group of corporations;trades or businesses under common con-trol.(1) In general.(2) Definition of trade or business.(3) Determination of common control.(4) Examples.(b) Minimum base period researchexpenses.(c) Tax accounting periods used.(1) In general.(2) Special rule where timing of researchis manipulated.(d) Membership during taxable year inmore 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.

§1.41–7 Special rules.

(a) Allocations.(1) Corporation making an election undersubchapter S.(i) Pass-through, for taxable years begin-ning after December 31, 1982, in the caseof an S corporation.(ii) Pass-through, for taxable years begin-ning before January 1, 1983, in the case ofa subchapter S corporation.(2) Pass-through in the case of an estate ortrust.(3) Pass-through in the case of a partner-ship.(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 acquisitionsand dispositions—Meaning of terms.(c) Special rule for pass-through of credit.(d) Carryback and carryover of unusedcredits.

§1.41–8 Special rules for taxable yearsending on or after January 3, 2001.

(a) Alternative incremental credit.(b) Election.(1) In general.(2) Time and manner of election.(3) Revocation.(4) Effective date.

Par. 5. Section 1.41–1 is revised to readas follows:

§1.41–1 Credit for increasing researchactivities.

(a) Amount of credit. The amount of ataxpayer’s credit is determined under sec-tion 41(a). For taxable years beginningafter June 30, 1996, and at the election ofthe taxpayer, the portion of the creditdetermined under section 41(a)(1) may becalculated using the alternative incremen-tal credit set forth in section 41(c)(4).

(b) Introduction to regulations undersection 41. (1) Sections 1.41–2 through1.41–8 and 1.41–3A through 1.41–5Aaddress only certain provisions of section41. The following table identifies the pro-visions of section 41 that are addressed,and lists each provision with the sectionof the regulations in which it is covered.

Section of the Section of theregulation Internal Revenue Code

§1.41–2 41(b)

§1.41–3 41(c)

§1.41–4 41(d)

§1.41–5 41(e)

§1.41–6 41(f)

§1.41–7 41(f)41(g)

§1.41–8 41(c)

§1.41–3A 41(c) (taxable years beginning before January 1, 1990)

§1.41–4A 41(d) (taxable years beginning before January 1, 1986)

§1.41–5A 41(e) (taxable years beginning before January 1, 1987)

(2) Section 1.41–3A also addresses thespecial rule in section 221(d)(2) of theEconomic Recovery Tax Act of 1981relating to taxable years overlapping theeffective dates of section 41. Section 41was formerly designated as sections 30

and 44F. Sections 1.41–0 through 1.41–8and 1.41–0A through 1.41–5A refer tothese sections as section 41 for conformi-ty purposes. Whether section 41, formersection 30, or former section 44F appliesto a particular expenditure depends upon

when the expenditure was paid orincurred.

§1.41-2 [Amended]

Par. 6. Section 1.41-2 is amended asfollows:

2001–5 I.R.B. 443 January 29, 2001

1. The last sentence of paragraph(a)(3)(i) is amended by removing the lan-guage “§1.41–5(d)(2)” and adding“§1.41–4A(d)(2)” in its place.

2. The last sentence of paragraph(a)(3)(ii) is amended by removing the lan-guage “§1.41–5(d)(3)” and adding“§1.41–4A(d)(3)” in its place.

3. The last sentence of paragraph(a)(4)(ii)(F) is amended by removing thelanguage “§1.41–9(a)(3)(ii)” and adding“§1.41–7(a)(3)(ii)” in its place.

4. Paragraph (e)(1)(i) is amended byremoving the language “§1.41–5” andadding “§1.41–4 or 1.41–4A, whicheveris applicable” in its place.

§§1.41–0A through 1.41–8A[Removed]

Par. 6A. Sections 1.41–0A through1.41–8A and the undesignated center-heading preceding these sections areremoved.

Par. 7. An undesignated centerheadingis added immediately following §1.44B–1to read as follows:

RESEARCH CREDIT—FORTAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1990

§1.41–3 [Redesignated as §1.41–3A]

Par. 8. Section 1.41–3 is redesignated as§1.41–3A and added under the new undes-ignated centerheading “RESEARCHCREDIT—FOR TAXABLE YEARSBEGINNING BEFORE JANUARY 1,1990.”

Par. 9. New §1.41–3 is added to read asfollows:

§1.41–3 Base amount for taxable yearsbeginning on or after January 3, 2001.

(a) New taxpayers. If, with respect toany credit year, the taxpayer has not beenin existence for any previous taxable year,the average annual gross receipts of thetaxpayer for the four taxable years pre-ceding the credit year shall be zero. If,with respect to any credit year, the tax-payer has been in existence for at least oneprevious taxable year, but has not been inexistence for four taxable years precedingthe taxable year, then the average annualgross receipts of the taxpayer for the fourtaxable years preceding the credit yearshall be the average annual gross receipts

for the number of taxable years precedingthe credit year for which the taxpayer hasbeen in existence.

(b) Special rules for short taxableyears—(1) Short credit year. If a credityear is a short taxable year, then the baseamount determined under section 41(c)(1)(but not section 41(c)(2)) shall be modi-fied by multiplying that amount by thenumber of months in the short taxableyear and dividing the result by 12.

(2) Short taxable year preceding credityear. If one or more of the four taxableyears preceding the credit year is a shorttaxable year, then the gross receipts forsuch year are deemed to be equal to thegross receipts actually derived in that yearmultiplied by 12 and divided by the num-ber of months in that year.

(3) Short taxable year in determiningfixed-base percentage. No adjustmentshall be made on account of a short tax-able year to the computation of a taxpay-er’s fixed-base percentage.

(c) Definition of gross receipts—(1) Ingeneral. For purposes of section 41, grossreceipts means the total amount, as deter-mined under the taxpayer’s method ofaccounting, derived by the taxpayer fromall its activities and from all sources (e.g.,revenues derived from the sale of inventorybefore reduction for cost of goods sold).

(2) Amounts excluded. For purposes ofthis paragraph (c), gross receipts do notinclude amounts representing—

(i) Returns or allowances;(ii) Receipts from the sale or exchange

of capital assets, as defined in section1221;

(iii) Repayments of loans or similarinstruments (e.g., a repayment of the prin-cipal amount of a loan held by a commer-cial lender);

(iv) Receipts from a sale or exchangenot in the ordinary course of business,such as the sale of an entire trade or busi-ness or the sale of property used in a tradeor business as defined under section1221(2);

(v) Amounts received with respect tosales tax or other similar state and localtaxes if, under the applicable state or locallaw, the tax is legally imposed on the pur-chaser of the good or service, and the tax-payer merely collects and remits the tax tothe taxing authority; and

(vi) Amounts received by a taxpayer ina taxable year that precedes the first tax-

able year in which the taxpayer derivesmore than $25,000 in gross receipts otherthan investment income. For purposes ofthis paragraph (c)(2)(vi), investmentincome is interest or distributions withrespect to stock (other than the stock of a20-percent owned corporation as definedin section 243(c)(2).

(3) Foreign corporations. For purposesof section 41, in the case of a foreign cor-poration, gross receipts include only grossreceipts that are effectively connectedwith the conduct of a trade or businesswithin the United States, theCommonwealth of Puerto Rico, or otherpossessions of the United States. See sec-tion 864(c) and applicable regulationsthereunder for the definition of effectivelyconnected income.

(d) Consistency requirement—(1) Ingeneral. In computing the credit forincreasing research activities for taxableyears beginning after December 31, 1989,qualified research expenses and grossreceipts taken into account in computing ataxpayer’s fixed-base percentage and ataxpayer’s base amount must be deter-mined on a basis consistent with the defi-nition of qualified research expenses andgross receipts for the credit year, withoutregard to the law in effect for the taxableyears taken into account in computing thefixed-base percentage or the base amount.This consistency requirement applies evenif the period for filing a claim for credit orrefund has expired for any taxable yeartaken into account in computing the fixed-base percentage or the base amount.

(2) Illustrations. The following exam-ples illustrate the application of the con-sistency rule of paragraph (d)(1) of thissection:

Example 1. (i) X, an accrual method taxpayerusing the calendar year as its taxable year, incursqualified research expenses in 2001. X wants tocompute its research credit under section 41 for thetax year ending December 31, 2001. As part of thecomputation, X must determine its fixed-base per-centage, which depends in part on X’s qualifiedresearch expenses incurred during the fixed-baseperiod, the taxable years beginning after December31, 1983, and before January 1, 1989.

(ii) During the fixed-base period, X reported thefollowing amounts as qualified research expenses onits Form 6765:

1984 . . . . . . . . . . . . . . . . . . . . . . .$ 100x1985 . . . . . . . . . . . . . . . . . . . . . . . . 120x1986 . . . . . . . . . . . . . . . . . . . . . . . . 150x1987 . . . . . . . . . . . . . . . . . . . . . . . . 180x1988 . . . . . . . . . . . . . . . . . . . . . . . . 170xTotal . . . . . . . . . . . . . . . . . . . . . . .$ 720x

January 29, 2001 444 2001–5 I.R.B.

(iii) For the taxable years ending December 31,1984, and December 31, 1985, X based the amountsreported as qualified research expenses on the defini-tion of qualified research in effect for those taxableyears. The definition of qualified research changed fortaxable years beginning after December 31, 1985. If Xused the definition of qualified research applicable toits taxable year ending December 31, 2001, the credityear, its qualified research expenses for the taxableyears ending December 31, 1984, and December 31,1985, would be reduced to $ 80x and $ 100x, respec-tively. Under the consistency rule in section 41(c)(5)and paragraph (d)(1) of this section, to compute theresearch credit for the tax year ending December 31,2001, X must reduce its qualified research expensesfor 1984 and 1985 to reflect the change in the defini-tion of qualified research for taxable years beginningafter December 31, 1985. Thus, X’s total qualifiedresearch expenses for the fixed-base period (1984-1988) to be used in computing the fixed-base percent-age is $ 80 + 100 + 150 + 180 + 170 = $ 680x.

Example 2. The facts are the same as in Example1, except that, in computing its qualified researchexpenses for the taxable year ending December 31,2001, X claimed that a certain type of expenditureincurred in 2001 was a qualified research expense.X’s claim reflected a change in X’s position, becauseX had not previously claimed that similar expendi-tures were qualified research expenses. The consis-tency rule requires X to adjust its qualified researchexpenses in computing the fixed-base percentage toinclude any similar expenditures not treated as qual-ified research expenses during the fixed-base period,regardless of whether the period for filing a claim forcredit or refund has expired for any year taken intoaccount in computing the fixed-base percentage.

(e) Effective date. The rules in para-graphs (c) and (d) of this section areapplicable for taxable years beginning onor after the date final regulations are pub-lished in the Federal Register.

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

§1.41-4 Qualified research forexpenditures paid or incurred on or afterJanuary 3, 2001.

(a) Qualified research—(1) General rule.Research activities related to the develop-ment or improvement of a business compo-nent constitute qualified research only if theresearch activities meet all of the require-ments of section 41(d)(1) and this section,and are not otherwise excluded under section41(d)(3)(B) or (d)(4), or this section.

(2) Requirements of section 41(d)(1).Research constitutes qualified researchonly if it is research—

(i) With respect to which expendituresmay be treated as expenses under section174, see §1.174-2;

(ii) That is undertaken for the purposeof discovering information that is techno-logical in nature, and the application of

which is intended to be useful in thedevelopment of a new or improved busi-ness component of the taxpayer; and

(iii) Substantially all of the activities ofwhich constitute elements of a process ofexperimentation that relates to a new orimproved function, performance, reliabil-ity or quality.

For certain recordkeeping require-ments, see paragraph (d) of this section.

(3) Undertaken for the purpose of dis-covering information—(i) In general. Forpurposes of section 41(d) and this section,research is undertaken for the purpose ofdiscovering information only if it isundertaken to obtain knowledge thatexceeds, expands, or refines the commonknowledge of skilled professionals in aparticular field of science or engineering.A determination that research is undertak-en for the purpose of discovering informa-tion does not require that the taxpayersucceed in obtaining the knowledge thatexceeds, expands, or refines the commonknowledge of skilled professionals in aparticular field of science or engineering,nor does it require that the advance soughtbe more than evolutionary. However,research is not undertaken for the purposeof discovering information merelybecause an expenditure may be treated asan expense under section 174.

(ii) Common knowledge. Commonknowledge of skilled professionals in aparticular field of science or engineeringmeans information that should be knownto skilled professionals had they per-formed, before the research in question isundertaken, a reasonable investigation ofthe existing level of information in theparticular field of science or engineering.Thus, knowledge may, in certain circum-stances, exceed, expand, or refine thecommon knowledge of skilled profession-als in a particular field of science or engi-neering even though such knowledge haspreviously been obtained by other per-sons. For example, trade secrets general-ly are not within the common knowledgeof skilled professionals in a particularfield of science or engineering becausethey are not reasonably available toskilled professionals not employed, hired,or licensed by the owner of such tradesecrets.

(iii) Means of discovery. In seeking toobtain knowledge that exceeds, expands,or refines the common knowledge of

skilled professionals in a particular fieldof science or engineering, a taxpayer mayemploy existing technologies in a particu-lar field and may rely on existing princi-ples of science or engineering.

(iv) Patent safe harbor. For purposesof section 41(d) and paragraph (a)(3)(i) ofthis section, the issuance of a patent by thePatent and Trademark Office under theprovisions of section 151 of title 35,United States Code (other than a patentfor design issued under the provisions ofsection 171 of title 35, United StatesCode) is conclusive evidence that a tax-payer has obtained knowledge thatexceeds, expands, or refines the commonknowledge of skilled professionals.However, the issuance of such a patent isnot a precondition for credit availability.

(v) Rebuttable presumption. If a tax-payer demonstrates with credible evidencethat research activities were undertaken toobtain the information described in thetaxpayer’s contemporaneous documenta-tion required under paragraph (d)(1) ofthis section, and if that documentation alsosets forth the basis for the taxpayer’s beliefthat obtaining this information wouldexceed, expand, or refine the commonknowledge of skilled professionals in theparticular field of science or engineering,the research activities are presumed to sat-isfy the requirements of this paragraph(a)(3). However, the presumption appliesonly if the taxpayer cooperates with rea-sonable requests by the Commissioner forwitnesses, information, documents, meet-ings, and interviews. Furthermore, theCommissioner may overcome the pre-sumption in this paragraph if theCommissioner demonstrates that the infor-mation described in the taxpayer’s docu-mentation was within the common knowl-edge of skilled professionals (as describedin paragraph (a)(3)(ii) of this section), orthat the research activities were not under-taken to obtain the information describedin the taxpayer’s documentation.

(4) Technological in nature. For pur-poses of section 41(d) and this section,information is technological in nature ifthe process of experimentation used todiscover such information fundamentallyrelies on principles of the physical or bio-logical sciences, engineering, or computerscience.

(5) Process of experimentation. Forpurposes of section 41(d) and this section,

2001–5 I.R.B. 445 January 29, 2001

a process of experimentation is a processto evaluate more than one alternativedesigned to achieve a result where thecapability or method of achieving thatresult is uncertain at the outset. A processof experimentation does not include theevaluation of alternatives to establish theappropriate design of a business compo-nent, if the capability and method fordeveloping or improving the businesscomponent are not uncertain. A processof experimentation in the physical or bio-logical sciences, engineering, or computerscience may involve—

(i) Developing one or more hypothesesdesigned to achieve the intended result;

(ii) Designing an experiment (that,where appropriate to the particular field ofresearch, is intended to be replicable withan established experimental control) totest and analyze those hypotheses(through, for example, modeling, simula-tion, or a systematic trial and errormethodology);

(iii) Conducting the experiment; and (iv) Refining or discarding the hypotheses

as part of a sequential design process todevelop or improve the business component.

(6) Substantially all requirement. Thesubstantially all requirement of section41(d)(1)(C) and paragraph (a)(2)(iii) of thissection is satisfied only if 80 percent ormore of the research activities, measuredon a cost or other consistently applied rea-sonable basis (and without regard to §1.41-2(d)(2)), constitute elements of a process ofexperimentation for a purpose described insection 41(d)(3). The substantially allrequirement is applied separately to eachbusiness component.

(7) Use of computers and informationtechnology. The employment of comput-ers or information technology, or thereliance on principles of computer scienceor information technology to store, col-lect, manipulate, translate, disseminate,produce, distribute, or process data orinformation, and similar uses of comput-ers and information technology does notitself establish that qualified research hasbeen undertaken.

(8) Illustrations. The following exam-ples illustrate the application of this para-graph (a):

Example 1. (i) Facts. X and other ma