IRS Finalizes Rules for Research Expenditures

The Internal Revenue Service has released final regulations to amend the definition of research and experimental expenditures, providing guidance for taxpayers engaged in research activities on the treatment of amounts paid or incurred in connection with the development of tangible property, including pilot models.

Last September, the IRS and the Treasury Department issued a notice of proposed rulemaking proposing a number of revisions to the current regulations. First, to counter an interpretation that Section 174 eligibility can be reversed by a subsequent event, the proposed regulations provided that the ultimate success, failure, sale or other use of the research or property resulting from research or experimentation is not relevant to a determination of eligibility under Section 174.

Second, the proposed regulations amended the Tax Code to provide that the Depreciable Property Rule in Sections 1.174-2(b)(1) and 1.174-2(b)(4)) is an application of the general definition of research or experimental expenditures provided for in Section 1.174-2(a)(1) and should not be applied to exclude otherwise eligible expenditures.

Third, the proposed regulations defined the term “pilot model” as any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during its development or improvement. The term included a fully functional representation or model of the product or a component of a product.

Fourth, the proposed regulations clarified the general rule that the costs of producing a product after uncertainty concerning the development or improvement of a product is eliminated are not eligible under Section 174 because these costs are not for research or experimentation.

Finally, the proposed regulations provided a “shrinking-back rule” to address situations in which the requirements are met with respect to only a component part of a larger product and are not met with respect to the overall product itself.

The proposed regulations also provided new examples applying the foregoing provisions.

Some commentators requested a definition of “uncertainty” because the examples rely on “elimination of uncertainty” as the point when research activities have concluded. However, the IRS decided that because the current regulations already provide a sufficient definition of “uncertainty,” and the point at which uncertainty is eliminated (that is, information available to the taxpayer establishes the capability or method for developing or improving the product or the appropriate design of the product) is based on the taxpayer’s facts and circumstances, the final regulations do not provide additional guidance with respect to the definition of “uncertainty.”

Other commenters also requested a bright-line standard, such as the commencement of commercial production, to determine when uncertainty is eliminated. But the IRS decided that the point at which uncertainty is resolved is based on the taxpayer’s facts and circumstances, and therefore a bright-line standard is not appropriate.

Some commentators also requested that the regulations explicitly incorporate the rule of application regarding the discovering information requirement. That is, there is no requirement that the taxpayer be seeking to obtain information that exceeds, expands or refines the common knowledge of skilled professionals in the particular field, and there is no requirement that the taxpayer succeed in developing a new or improved business component.

The IRS and the Treasury Department noted that Section 174 does not contain any provision defining research or experimentation. In contrast, Section 41 provides a statutory definition for “qualified research,” which includes a requirement that the research be undertaken for the purpose of discovering information. In addition, neither the Section 174 statute nor its legislative history suggest that a taxpayer must seek information that exceeds, expands or refines the common knowledge of skilled professionals in the particular field in which the taxpayer is performing research. Section 1.174-2(a)(1) of the current regulations simply provides that “[e]xpenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.” Consequently, this suggestion was not adopted in the final regulations.