[Code of Federal Regulations]
[Title 26, Volume 1]
[Revised as of April 1, 2003]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.41-4]

[Page 120-129]
 
                       TITLE 26--INTERNAL REVENUE
 
     CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
 
PART 1--INCOME TAXES--Table of Contents
 
Sec. 1.41-4  Qualified research for expenditures paid or incurred on or after January 3, 2001.

    (a) Qualified research--(1) General rule. Research activities 
related to the development or improvement of a business component 
constitute qualified research only if the research activities meet all 
of the requirements of section 41(d)(1) and this section, and are not 
otherwise excluded under section 41(d)(3)(B) or (d)(4), or this section.
    (2) Requirements of section 41(d)(1). Research constitutes qualified 
research only if it is research--
    (i) With respect to which expenditures may be treated as expenses 
under section 174, see Sec. 1.174-2;
    (ii) That is undertaken for the purpose of discovering information 
that is technological in nature, and the application of which is 
intended to be useful in the development of a new or improved business 
component of the taxpayer; and
    (iii) Substantially all of the activities of which constitute 
elements of a process of experimentation that relates to a new or 
improved function, performance, reliability or quality.


For certain recordkeeping requirements, see paragraph (d) of this 
section.
    (3) Undertaken for the purpose of discovering information--(i) In 
general. For purposes of section 41(d) and this section, research is 
undertaken for the purpose of discovering information only if it is 
undertaken to obtain knowledge that exceeds, expands, or refines the 
common knowledge of skilled professionals in a particular field of 
science or engineering. A determination that research is undertaken for 
the purpose of discovering information does not require that the 
taxpayer succeed in obtaining the knowledge that exceeds, expands, or 
refines the common knowledge of skilled professionals in a particular 
field of science or engineering, nor does it require that the advance 
sought be more than evolutionary. However, research is not undertaken 
for the purpose of discovering information merely because an expenditure 
may be treated as an expense under section 174.
    (ii) Common knowledge. Common knowledge of skilled professionals in 
a particular field of science or engineering means information that 
should be known to skilled professionals had they performed, before the 
research in question is undertaken, a reasonable investigation of the 
existing level of information in the particular field of science or 
engineering. Thus, knowledge may, in certain circumstances, exceed, 
expand, or refine the common knowledge of skilled professionals in a 
particular field of science or engineering even though such knowledge 
has previously been obtained by other persons. For example, trade 
secrets generally are not within the common knowledge of skilled 
professionals in a particular field of science or engineering because 
they are not reasonably available to skilled professionals not employed, 
hired, or licensed by the owner of such trade secrets.

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    (iii) Means of discovery. In seeking to obtain knowledge that 
exceeds, expands, or refines the common knowledge of skilled 
professionals in a particular field of science or engineering, a 
taxpayer may employ existing technologies in a particular field and may 
rely on existing principles of science or engineering.
    (iv) Patent safe harbor. For purposes of section 41(d) and paragraph 
(a)(3)(i) of this section, the issuance of a patent by the Patent and 
Trademark Office under the provisions of section 151 of title 35, United 
States Code (other than a patent for design issued under the provisions 
of section 171 of title 35, United States Code) is conclusive evidence 
that a taxpayer has obtained knowledge that exceeds, expands, or refines 
the common knowledge of skilled professionals. However, the issuance of 
such a patent is not a precondition for credit availability.
    (v) Rebuttable presumption. If a taxpayer demonstrates with credible 
evidence that research activities were undertaken to obtain the 
information described in the taxpayer's contemporaneous documentation 
required under paragraph (d)(1) of this section, and if that 
documentation also sets forth the basis for the taxpayer's belief that 
obtaining this information would exceed, expand, or refine the common 
knowledge of skilled professionals in the particular field of science or 
engineering, the research activities are presumed to satisfy the 
requirements of this paragraph (a)(3). However, the presumption applies 
only if the taxpayer cooperates with reasonable requests by the 
Commissioner for witnesses, information, documents, meetings, and 
interviews. Furthermore, the Commissioner may overcome the presumption 
in this paragraph if the Commissioner demonstrates that the information 
described in the taxpayer's documentation was within the common 
knowledge of skilled professionals (as described in paragraph (a)(3)(ii) 
of this section), or that the research activities were not undertaken to 
obtain the information described in the taxpayer's documentation.
    (4) Technological in nature. For purposes of section 41(d) and this 
section, information is technological in nature if the process of 
experimentation used to discover such information fundamentally relies 
on principles of the physical or biological sciences, engineering, or 
computer science.
    (5) Process of experimentation. For purposes of section 41(d) and 
this section, a process of experimentation is a process to evaluate more 
than one alternative designed to achieve a result where the capability 
or method of achieving that result is uncertain at the outset. A process 
of experimentation does not include the evaluation of alternatives to 
establish the appropriate design of a business component, if the 
capability and method for developing or improving the business component 
are not uncertain. A process of experimentation in the physical or 
biological sciences, engineering, or computer science may involve--
    (i) Developing one or more hypotheses designed to achieve the 
intended result;
    (ii) Designing an experiment (that, where appropriate to the 
particular field of research, is intended to be replicable with an 
established experimental control) to test and analyze those hypotheses 
(through, for example, modeling, simulation, or a systematic trial and 
error methodology);
    (iii) Conducting the experiment; and
    (iv) Refining or discarding the hypotheses as part of a sequential 
design process to develop or improve the business component.
    (6) Substantially all requirement. The substantially all requirement 
of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this section is 
satisfied only if 80 percent or more of the research activities, 
measured on a cost or other consistently applied reasonable basis (and 
without regard to Sec. 1.41-2(d)(2)), constitute elements of a process 
of experimentation for a purpose described in section 41(d)(3). The 
substantially all requirement is applied separately to each business 
component.
    (7) Use of computers and information technology. The employment of 
computers or information technology, or the reliance on principles of 
computer science or information technology to store, collect, 
manipulate, translate, disseminate, produce, distribute, or

[[Page 122]]

process data or information, and similar uses of computers and 
information technology does not itself establish that qualified research 
has been undertaken.
    (8) Illustrations. The following examples illustrate the application 
of this paragraph (a):

    Example 1. (i) Facts. X and other manufacturing companies have 
previously designed and manufactured a particular kind of machine using 
Material S. Material T is less expensive than Material S. X wishes to 
design a new machine that appears and functions exactly the same as its 
existing machines, but that is made of Material T instead of Material S. 
The capability and method necessary to achieve this objective should not 
have been known to skilled professionals had they conducted a reasonable 
investigation of the existing information in the relevant field of 
science or engineering at the time the research was undertaken.
    (ii) Conclusion. X's activities to design the new machine using 
Material T may be qualified research within the meaning of section 
41(d)(1) and this paragraph (a). In seeking to design the machine, X 
undertook to obtain knowledge that exceeds, expands, or refines the 
common knowledge of skilled professionals in the relevant field of 
science or engineering.
    Example 2. (i) Facts. X is engaged in the business of developing and 
manufacturing widgets. X wants to manufacture an improved widget made 
out of a material that X has not previously used. Although X is 
uncertain how to use the material to manufacture an improved widget, the 
capability and method of using the material to manufacture such widgets 
should have been known to skilled professionals had they conducted a 
reasonable investigation of the existing level of information in the 
particular field of science or engineering at the time the research was 
undertaken.
    (ii) Conclusion. Even though X's expenditures for the activities to 
resolve the uncertainty in manufacturing the improved widget may be 
treated as expenses for research activities under section 174 and 
Sec. 1.174-2, X's activities to resolve the uncertainty in manufacturing 
the improved widget are not qualified research within the meaning of 
section 41(d) and this paragraph (a). Although X's activities were 
intended to eliminate uncertainty, the activities were not undertaken to 
obtain knowledge that exceeds, expands, or refines the common knowledge 
of skilled professionals in the relevant field of science or 
engineering.
    Example 3. (i) Facts. X desires to build a bridge that can sustain 
greater traffic flow without deterioration than can existing bridges. 
The capability and method used to build such a bridge should not have 
been known to skilled professionals had they conducted a reasonable 
investigation of the existing level of information in the particular 
field of science or engineering at the time the research was undertaken. 
X eventually abandons the project after attempts to develop the 
technology prove unsuccessful.
    (ii) Conclusion. X's activities to develop the technology to build 
the bridge may be qualified research within the meaning of section 
41(d)(1) and this paragraph (a), regardless of the fact that X did not 
actually succeed in developing that technology. In seeking to develop 
the technology, X undertook to obtain knowledge that exceeds, expands, 
or refines the common knowledge of skilled professionals in the relevant 
field of science or engineering.
    Example 4. (i) Facts. The facts are the same as in Example 3, except 
that Y successfully builds a bridge that can sustain the greater traffic 
flow. Thereafter, Z seeks to build a bridge that can also sustain such 
greater traffic flow. The method Y used to build its bridge is a closely 
guarded trade secret that is not known to Z and should not have been 
known to skilled professionals had they conducted a reasonable 
investigation of the existing level of information in the particular 
field of science or engineering at the time the research was undertaken.
    (ii) Conclusion. Z's activities to develop the technology to build 
the bridge may be qualified research within the meaning of section 
41(d)(1) and this paragraph (a), even if it so happens that the 
technology Z used to build its bridge is similar or identical to the 
technology Y used. In developing the technology, Z undertook to obtain 
knowledge that exceeds, expands, or refines the common knowledge of 
skilled professionals in the relevant field of science or engineering.
    Example 5. (i) Facts. X, a widget manufacturer, seeks to develop a 
new widget and initiates Project A. Before or during the early stages of 
Project A, X's employees prepare contemporaneous documentation that 
describes the principal questions to be answered by Project A and the 
information that X seeks to obtain to exceed, expand, or refine the 
common knowledge of skilled professionals in the relevant field of 
science or engineering. The documentation includes a statement from one 
of X's skilled professionals setting forth the basis for that 
professional's belief that the information is beyond the common 
knowledge of skilled professionals in the relevant field. Upon 
examination by the Commissioner, X presents credible evidence that the 
research activities were undertaken to obtain the information described 
in the contemporaneous documentation. X cooperates with all requests by 
the IRS for witnesses, information, documents, meetings, and interviews.

[[Page 123]]

    (ii) Conclusion. X's research activities with respect to Project A 
are presumed to be undertaken for the purpose of obtaining knowledge 
that exceeds, expands, or refines the common knowledge of skilled 
professionals in the relevant field of science or engineering. The 
Commissioner may overcome this presumption by demonstrating that the 
information X sought to obtain was within the common knowledge of 
skilled professionals in the relevant field of science or engineering 
(i.e., by demonstrating that, at the time Project A began, the 
information should have been known to skilled professionals had they 
performed a reasonable investigation of the existing level of knowledge 
in the relevant field).

    (b) Application of requirements for qualified research--(1) In 
general. The requirements for qualified research in section 41(d)(1) and 
paragraph (a) of this section, must be applied separately to each 
business component, as defined in section 41(d)(2)(B). In cases 
involving development of both a product and a manufacturing or other 
commercial production process for the product, research activities 
relating to development of the process are not qualified research unless 
the requirements of section 41(d) and this section are met for the 
research activities relating to the process without taking into account 
the research activities relating to development of the product. 
Similarly, research activities relating to development of the product 
are not qualified research unless the requirements of section 41(d) and 
this section are met for the research activities relating to the product 
without taking into account the research activities relating to 
development of the manufacturing or other commercial production process.
    (2) Shrinking-back rule. The requirements of section 41(d) and 
paragraph (a) of this section are to be applied first at the level of 
the discrete business component, that is, the product, process, computer 
software, technique, formula, or invention to be held for sale, lease, 
or license, or used by the taxpayer in a trade or business of the 
taxpayer. If the requirements for credit eligibility are met at that 
first level, then some or all of the taxpayer's research expenses are 
eligible for the credit. A special shrinking-back ruleapplies in the 
case where a taxpayer incurs some research expenses with respect to that 
discrete business component that would constitute qualified research 
expenses with respect to that business component but for the fact that 
less than substantially all of the research activities with respect to 
that component constitute elements of a process of experimentation that 
relates to a new or improved function, performance, reliability or 
quality. In such a case, the requirements for the credit are to be 
applied at the next most significant subset of elements of the business 
component. The shrinking-back of the applicable business component 
continues until a subset or series of subsets of elements of the 
business component satisfies substantially all requirements of section 
41(d)(1)(C) and paragraph (a)(2)(iii) of this section (treating that 
subset of elements as a business component) or the most basic element 
fails to satisfy the requirements. This shrinking-back rule is applied 
only if a taxpayer does not satisfy the requirements of section 
41(d)(1)(C) and paragraph (a)(2)(iii) of this section with respect to 
the overall business component. The shrinking-back rule is not itself 
applied as a reason to exclude research activities from credit 
eligibility.
    (3) Illustration. The following example illustrates the application 
of this paragraph (b):

    (i) Facts. X, a widget manufacturer, develops a widget that is 
improved in several respects. Among the various improvements to the 
widget is an improvement to the widget's cooling mechanism. Although the 
capability and method of making the other improvements to the widget 
would have been known to skilled professionals had they conducted a 
reasonable investigation of the existing level of information in the 
particular field of science or engineering, the method of developing the 
improved cooling mechanism and of incorporating the improved mechanism 
into the widget would not have been known to skilled professionals had 
they conducted a reasonable investigation of the existing level of 
information in the particular field of science or engineering. 
Substantially all of X's research activities in improving the widget 
constitute elements of a process of experimentation

[[Page 124]]

for purposes of improving the performance of the widget. None of X's 
research activities in improving the widget are described in section 
41(d)(4) or paragraph (c) of this section.
    (ii) Conclusion. Some, but not all, of X's research activities in 
developing the improved widget are qualified research within the meaning 
of section 41(d)(1) and paragraph (a) of this section. In seeking to 
improve the widget, some of X's activities (related to improving the 
cooling mechanism and incorporating the improved cooling mechanism into 
the widget) were undertaken to obtain knowledge that exceeds, expands, 
or refines the common knowledge of skilled professionals in the relevant 
field of science or engineering. However, other activities (related to 
the other improvements) were not undertaken to obtain knowledge that 
exceeds, expands, or refines the common knowledge of skilled 
professionals in the relevant field of science or engineering, and thus 
are not qualified research and are not eligible for the credit. Not all 
of X's research activities relating to the widget are eligible for the 
credit because some of the activities are not qualified research as 
defined in section 41(d) and paragraph (a) of this section, even though 
the widget qualifies as a business component with respect to which 
qualified research that satisfies the requirements of section 41(d) and 
paragraph (a) of this section is undertaken.

    (c) Excluded activities--(1) In general. Qualified research does not 
include any activity described in section 41(d)(4) and paragraph (c) of 
this section.
    (2) Research after commercial production--(i) In general. Activities 
conducted after the beginning of commercial production of a business 
component are not qualified research. Activities are conducted after the 
beginning of commercial production of a business component if such 
activities are conducted after the component is developed to the point 
where it is ready for commercial sale or use, or meets the basic 
functional and economic requirements of the taxpayer for the component's 
sale or use.
    (ii) Certain additional activities related to the business 
component. The following activities are deemed to occur after the 
beginning of commercial production of a business component--
    (A) Preproduction planning for a finished business component;
    (B) Tooling-up for production;
    (C) Trial production runs;
    (D) Trouble shooting involving detecting faults in production 
equipment or processes;
    (E) Accumulating data relating to production processes; and
    (F) Debugging flaws in a business component.
    (iii) Activities related to production process or technique. In 
cases involving development of both a product and a manufacturing or 
other commercial production process for the product, the exclusion 
described in section 41(d)(4)(A) and paragraphs (c)(2)(i) and (ii) of 
this section applies separately for the activities relating to the 
development of the product and the activities relating to the 
development of the process. For example, even after a product meets the 
taxpayer's basic functional and economic requirements, activities 
relating to the development of the manufacturing process still may 
constitute qualified research, provided that the development of the 
process itself separately satisfies the requirements of section 41(d) 
and this section, and the activities are conducted before the process 
meets the taxpayer's basic functional and economic requirements or is 
ready for commercial use.
    (iv) Clinical testing. Clinical testing of a pharmaceutical product 
prior to its commercial production in the United States is not treated 
as occurring after the beginning of commercial production even if the 
product is commercially available in other countries. Additional 
clinical testing of a pharmaceutical product after a product has been 
approved for a specific therapeutic use by the Food and Drug 
Administration and is ready for commercial production and sale are not 
treated as occurring after the beginning of commercial production if 
such clinical tests are undertaken to establish new functional uses, 
characteristics, indications, combinations, dosages, or delivery forms 
for the product. A functional use, characteristic, indication, 
combination, dosage or delivery form shall

[[Page 125]]

be considered new only if such functional use, characteristic, 
indication, combination, dosage or delivery form must be approved by the 
Food and Drug Administration.
    (3) Adaptation of existing business components. Activities relating 
to adapting an existing business component to a particular customer's 
requirement or need are not qualified research. This exclusion does not 
apply merely because a business component is intended for a specific 
customer.
    (4) Duplication of existing business component. Activities relating 
to reproducing an existing business component (in whole or in part) from 
a physical examination of the business component itself or from plans, 
blueprints, detailed specifications, or publicly available information 
about the business component are not qualified research. This exclusion 
does not apply merely because the taxpayer inspects an existing business 
component in the course of developing its own business component.
    (5) Surveys, studies, research relating to management functions, 
etc. Qualified research does not include activities relating to--
    (i) Efficiency surveys;
    (ii) Management functions or techniques, including such items as 
preparation of financial data and analysis, development of employee 
training programs and management organization plans, and management-
based changes in production processes (such as rearranging work stations 
on an assembly line);
    (iii) Market research, testing, or development (including 
advertising or promotions);
    (iv) Routine data collections; or
    (v) Routine or ordinary testing or inspections for quality control.
    (6) Internal-use computer software--(i) General rule. Research with 
respect to computer software that is developed by (or for the benefit 
of) the taxpayer primarily for the taxpayer's internal use is eligible 
for the research credit only if the software satisfies the requirements 
of paragraph (c)(6)(ii) of this section.
    (ii) Requirements. The requirements of this paragraph (c)(6)(ii) 
are--
    (A) The research satisfies the requirements of section 41(d)(1);
    (B) The research is not otherwise excluded under section 41(d)(4) 
(other than section 41(d)(4)(E)); and (C) One of the following 
conditions is met--
    (1) The taxpayer develops the software for use in an activity that 
constitutes qualified research (other than the development of the 
internal-use software itself);
    (2) The taxpayer develops the software for use in a production 
process that meets the requirements of section 41(d)(1);
    (3) The taxpayer develops a new or improved package of computer 
software and hardware together as a single product, of which the 
software is an integral part, that is used directly by the taxpayer in 
providing technological services in its trade or business to customers. 
In these cases, eligibility for the research credit is to be determined 
by examining the combined hardware-software product as a single product;
    (4) The taxpayer develops the software for use in providing computer 
services to customers; or
    (5) The software satisfies the high threshold of innovation test of 
paragraph (c)(6)(vi) of this section.
    (iii) Primarily for internal use. Software is developed primarily 
for the taxpayer's internal use if the software is to be used 
internally, for example, in general administrative functions of the 
taxpayer (such as payroll, bookkeeping, or personnel management) or in 
providing noncomputer services (such as accounting, consulting or 
banking services). If computer software is developed primarily for the 
taxpayer's internal use, the requirements of paragraph (c)(6) apply even 
though the taxpayer intends to, or subsequently does, sell, lease, or 
license the computer software.
    (iv) Software used in the provision of services--(A) Computer 
services. For purposes of this section, a computer service is a service 
offered by a taxpayer to customers who conduct business with the 
taxpayer primarily for the use of the taxpayer's computer or software 
technology. A taxpayer does not provide a computer service merely 
because customers interact with the taxpayer's software.

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    (B) Noncomputer services. For purposes of this section, a 
noncomputer service is a service offered by a taxpayer to customers who 
conduct business with the taxpayer primarily to obtain a service other 
than a computer service, even if such other service is enabled, 
supported, or facilitated by computer or software technology.
    (v) Exception for certain software used in providing noncomputer 
services. The requirements of paragraph (c)(6)(ii)(C) of this section 
are deemed satisfied for research with respect to computer software if, 
at the time the research was undertaken--
    (A) The software is designed to provide customers a new feature with 
respect to a noncomputer service;
    (B) The taxpayer reasonably anticipated that customers would choose 
to obtain the noncomputer service from the taxpayer (rather than from 
the taxpayer's competitors) because of those new features provided by 
the software; and (C) Those new features were not available from any of 
the taxpayer's competitors.
    (vi) High threshold of innovation test. Computer software satisfies 
the high threshold of innovation test of this paragraph (c)(6)(vi) only 
if the taxpayer can establish that--
    (A) The software is innovative in that the software is intended to 
result in a reduction in cost, improvement in speed, or other 
improvement, that is substantial and economically significant;
    (B) The software development involves significant economic risk in 
that the taxpayer commits substantial resources to the development and 
there is a substantial uncertainty, because of technical risk, that such 
resources would be recovered within a reasonable period; and
    (C) The software is not commercially available for use by the 
taxpayer in that the software cannot be purchased, leased, or licensed 
and used for the intended purpose without modifications that would 
satisfy the requirements of paragraphs (c)(6)(vi)(A) and (B) of this 
section.
    (vii) Application of high threshold of innovation test. In 
determining if the high threshold of innovation test of paragraph 
(c)(6)(vi) of this section is satisfied, all of the facts and 
circumstances are considered. The determination of whether the software 
is intended to result in an improvement or cost reduction that is 
substantial and economically significant is based on a comparison of the 
intended result with software that is within the common knowledge of 
skilled professionals in the relevant field of science or engineering, 
see Sec. 1.41-4(a)(3)(ii). Similarly, the extent of uncertainty and 
technical risk is determined with respect to the common knowledge of 
skilled professionals in the relevant field of science or engineering. 
Further, in determining if the high threshold of innovation test of 
paragraph (c)(6)(vi) of this section is satisfied, the activities to 
develop the new or improved software are considered independent of the 
effect of any modifications to related hardware or other software.
    (viii) Illustrations. The following examples illustrate the 
application of this paragraph (c)(6):

    Example 1. (i) Facts. X is engaged in the business of manufacturing 
and selling widgets to wholesalers. X has experienced strong growth and 
at the same time has expanded its product offerings. X also has 
increased significantly the size of its business by expanding into new 
territories. The increase in the size and scope of its business has 
strained X's existing financial management systems such that management 
can no longer obtain timely comprehensive financial data. Accordingly, X 
undertakes the development of a financial management computer software 
system that is more appropriate to its newly expanded operations.
    (ii) Conclusion. X's new computer software system is developed by X 
primarily for X's internal use. X's activities to develop the new 
computer software system may be eligible for the research credit only if 
the computer software development activities satisfy the requirements of 
paragraph (c)(6)(ii) of this section.
    Example 2. (i) Facts. X is engaged in the business of designing, 
manufacturing, and selling widgets. X delivers its widgets in the same 
manner and time as its competitors. In keeping with X's corporate 
commitment to provide customers with top quality service, X undertakes a 
project to develop for X's internal use a computer software system to 
facilitate the tracking of the manufacturing and delivery of widgets 
which will enable X's customers to monitor the progress of their orders 
and know precisely when their widgets will be delivered. X's computer 
software activities include research activities that

[[Page 127]]

satisfy the discovery requirement in section 41(d)(1) and paragraph 
(a)(3) of this section. At the time the research is undertaken, X 
reasonably anticipates that if it is successful, X will increase its 
market share as compared to X's competitors, none of which has such a 
tracking feature for its delivery system.
    (ii) Conclusion. Although X's computer software system is developed 
primarily for X's internal use, X's activities are excepted from the 
high threshold of innovation test of paragraph (c)(6)(vi) of this 
section because, at the time the research is undertaken, X's software is 
designed to provide improved tracking features, X reasonably anticipates 
that customers will purchase widgets from X because these improved 
tracking features, and because comparable tracking features are not 
available from any of X's competitors.

    (ix) Effective dates. This paragraph (c)(6) is applicable for 
taxable years beginning after December 31, 1985, except paragraphs 
(c)(6)(ii)(C)(4), (c)(6)(iv)(A) and (B), (c)(6)(v), the second and third 
sentences of paragraph (c)(6)(vii), and paragraph (c)(6)(viii) Example 2 
of this section apply to expenditures paid or incurred on or after 
January 3, 2001.
    (7) Activities outside the United States, Puerto Rico, and other 
possessions--(i) In general. Research conducted outside the United 
States, as defined in section 7701(a)(9), the Commonwealth of Puerto 
Rico and other possessions of the United States does not constitute 
qualified research.
    (ii) Apportionment of in-house research expenses. In-house research 
expenses paid or incurred for qualified services performed both (A) in 
the United States, the Commonwealth of Puerto Rico and other possessions 
of the United States and (B) outside the United States, the Commonwealth 
of Puerto Rico and other possessions of the United States must be 
apportioned between the services performed in the United States, the 
Commonwealth of Puerto Rico and other possessions of the United States 
and the services performed outside the United States, the Commonwealth 
of Puerto Rico and other possessions of the United States. Only those 
in-house research expenses apportioned to the services performed within 
the United States, the Commonwealth of Puerto Rico and other possessions 
of the United States are eligible to be treated as qualified research 
expenses, unless the in-house research expenses are wages and the 80 
percent rule of Sec. 1.41-2(d)(2) applies.
    (iii) Apportionment of contract research expenses. If contract 
research is performed partly in the United States, the Commonwealth of 
Puerto Rico and other possessions of the United States and partly 
outside the United States, the Commonwealth of Puerto Rico and other 
possessions of the United States, only 65 percent (or 75 percent in the 
case of amounts paid to qualified research consortia) of the portion of 
the contract amount that is attributable to the research activity 
performed in the United States, the Commonwealth of Puerto Rico and 
other possessions of the United States may qualify as a contract 
research expense (even if 80 percent or more of the contract amount is 
for research performed in the United States, the Commonwealth of Puerto 
Rico and other possessions of the United States).
    (8) Research in the social sciences, etc. Qualified research does 
not include research in the social sciences (including economics, 
business management, and behavioral sciences), arts, or humanities.
    (9) Research funded by any grant, contract, or otherwise. Qualified 
research does not include any research to the extent funded by any 
grant, contract, or otherwise by another person (or governmental 
entity). To determine the extent to which research is so funded, 
Sec. 1.41-4A(d) applies.
    (10) Illustrations. The following examples illustrate provisions 
contained in paragraphs (c)(1) through (9) of this section. No inference 
should be drawn from these examples concerning the application of 
section 41(d)(1) and paragraph (a) of this section to these facts. The 
examples are as follows:

    Example 1. (i) Facts. X, a tire manufacturer, seeks to build a tire 
that will not deteriorate as rapidly under certain conditions of high 
speed and temperature as do existing tires. X commences laboratory 
research on January 1. On April 1, X determines in the laboratory that a 
certain combination of materials and additives can withstand higher 
rotational speeds and temperatures than the combination of materials and 
additives used in existing tires. On the basis of this determination, X 
undertakes further research activities to determine how to design a tire 
using those

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materials and additives, and to determine whether such a tire functions 
outside the laboratory as intended under various actual road conditions. 
By September 1, X's research has progressed to the point where the new 
tire meets X's basic functional and economic requirements.
    (ii) Conclusion. Any research activities conducted by X after 
September 1 with respect to the design of the tire are not qualified 
research within the meaning of section 41(d)(1) and paragraph (a) of 
this section because they are undertaken after the beginning of 
commercial production of the tire. Whether any activities X engaged in 
to develop a process for manufacturing the new tire constitute qualified 
research depends on if the development of the process itself separately 
satisfies the requirements of section 41(d) and paragraph (c)(2) of this 
section, and also depends on if the activities occur before the point in 
time when the process meets the taxpayer's basic functional and economic 
requirements or is ready for commercial use.
    Example 2. (i) Facts. For several years, X has manufactured and sold 
a particular kind of widget. X initiates a new research project to 
develop an improved widget.
    (ii) Conclusion. X's activities to develop an improved widget are 
not excluded from the definition of qualified research under section 
41(d)(4)(A) and paragraph (c)(2) of this section until the beginning of 
commercial production of the improved widget. The fact that X's 
activities relating to the improved widget are undertaken after the 
beginning of commercial production of the unimproved widget does not bar 
the activities from credit eligibility because those activities 
constitute a new research project to develop a new business component, 
an improved widget.
    Example 3. (i) Facts. X, a computer software development firm, owns 
all substantial rights in a general ledger accounting software core 
program that X markets and licenses to customers. X incurs expenditures 
in adapting the core software program to the requirements of C, one of 
X's customers.
    (ii) Conclusion. Because X's activities represent activities to 
adapt an existing software program to a particular customer's 
requirement, X's activities are excluded from the definition of 
qualified research under section 41(d)(4)(B) and paragraph (c)(3) of 
this section.
    Example 4. (i) Facts. The facts are the same as in Example 3, except 
that C pays X to adapt the core software program to C's requirements.
    (ii) Conclusion. Because X's activities are excluded from the 
definition of qualified research under section 41(d)(4)(B) and paragraph 
(c)(3) of this section, C's payments to X do not constitute contract 
research expenses under section 41(b)(3)(A).
    Example 5. (i) Facts. The facts are the same as in Example 3, except 
that C's own employees adapt the core software program to C's 
requirements.
    (ii) Conclusion. Because C's employees' activities are excluded from 
the definition of qualified research under section 41(d)(4)(B) and 
paragraph (c)(3) of this section, the wages C paid to its employees do 
not constitute in-house research expenses under section 41(b)(2)(A).
    Example 6. (i) Facts. An existing gasoline additive is manufactured 
by Y using three ingredients, A, B, and C. X seeks to develop and 
manufacture its own gasoline additive that appears and functions in a 
manner similar to Y's additive. To develop its own additive, X first 
inspects the composition of Y's additive, and uses knowledge gained from 
the inspection to reproduce A and B in the laboratory. Any differences 
between ingredients A and B that are used in Y's additive and those 
reproduced by X are insignificant and are not material to the viability, 
effectiveness, or cost of A and B. X desires to use with A and B an 
ingredient that has a materially lower cost than ingredient C. 
Accordingly, X engages in a process of experimentation to discover 
potential alternative formulations of the additive (i.e., the 
development and use of various ingredients other than C to use with A 
and B).
    (ii) Conclusion. X's activities in analyzing and reproducing 
ingredients A and B involve duplication of existing business components 
and are excluded from qualified research under section 41(d)(4)(C) and 
paragraph (c)(4) of this section. X's experimentation activities to 
discover potential alternative formulations of the additive do not 
involve duplication of an existing business component and are not 
excluded from qualified research under section 41(d)(4)(C) and paragraph 
(c)(4) of this section.
    Example 7. (i) Facts. X, an insurance company, develops a new life 
insurance product. In the course of developing the product, X engages in 
research with respect to the effect of pricing and tax consequences on 
demand for the product, the expected volatility of interest rates, and 
the expected mortality rates (based on published data and prior 
insurance claims).
    (ii) Conclusion. X's activities related to the new product represent 
research in the social sciences, and are thus excluded from qualified 
research under section 41(d)(4)(G) and paragraph (c)(8) of this section.

    (d) Documentation. No credit shall be allowed under section 41 with 
regard to an expenditure relating to a research project unless the 
taxpayer--
    (1) Prepares documentation before or during the early stages of the 
research project, that describes the principal

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questions to be answered and the information the taxpayer seeks to 
obtain to satisfy the requirements of paragraph (a)(3) of this section, 
and retains that documentation on paper or electronically in the manner 
prescribed in applicable regulations, revenue rulings, revenue 
procedures, or other appropriate guidance until such time as taxes may 
no longer be assessed (except under section 6501(c)(1), (2), or (3)) for 
any year in which the taxpayer claims to have qualified research 
expenditures in connection with the research project; and
    (2) Satisfies section 6001 and the regulations thereunder.
    (e) Effective dates. In general, the rules of this section are 
applicable for expenditures paid or incurred on or after January 3, 
2001. The rules of paragraph (d), however, apply to research projects 
that begin on or after March 5, 2001.

[T.D. 8930, 66 FR 290, Jan. 3, 2001]