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deduction provisions of section 162. Thus, for example, the credit generally is not available to a limited partnership (or to any partners in such partnership, including a general partner which is an operating company) for partnership expenditures for "outside" or contract research intended to be transferred by the partnership to another (such as to the general partner) in return for license or royalty payments.

As the only exception to the rule that the trade or business test for purposes of section 44F is the same as for purposes of section 162, the Treasury Department is to issue regulations, for credit purposes only, which will allow the credit in the case of a research joint venture between taxpayers which both (1) themselves satisfy the carrying on test (e.g., the research must be in a particular trade or business already being carried on by the taxpayer) and also (2) themselves are entitled to the research results.

Thus, the credit is not available for research expenditures paid or incurred by a taxpayer merely in connection with, but not in carrying on, a trade or business. Šimilarly, the credit is not available with respect to expenditures paid or incurred by a taxpayer as part of a financing arrangement or hobby. Also under the trade or business test, research expenditures of a taxpayer are eligible for the credit only if paid or incurred in a particular trade or business already being carried on (within the meaning of sec. 162) by the taxpayer.

Furthermore, in cases where an organization conducting research is deemed to be carrying on a trade or business under these rules (so that the credit is available for incremental research expenditures), the Congress determined that individual taxpayers with interests in the organization should not be able to utilize passthroughs of the credit to offset tax on income from unrelated sources. Thus, individuals (including partners and S corporation shareholders) to whom the credit is properly allocable may use the credit in a particular year only to offset the amount of tax attributable to that portion of the individual's taxable income which is applicable or apportionable to such interest. (A 15-year carryover is allowed for any unused credit.) Also, allocations of the credit among partners, etc., must be in accordance with rules prescribed in Treasury regulations.

Explanation of incremental credit

Definition of qualified research

General rule.-Subject to certain exclusions, the credit provision adopts the definition of research as used in section 174. That is, the term "qualified research" for purposes of section 44F has the same meaning, subject to the specified exclusions, as has the term "research or experimental" under section 174 (described above).

While the definition of research generally is the same for purposes both of section 174 deduction election and the credit, particular research expenditures which qualify for the section 174 deduction election may be ineligible for the credit, e.g., because the expenditures fail to satisfy the section 162 trade or business requirement for the credit, because the expenditures do not fall within the categories of research expenditures (such as direct research wages)

which qualify for the credit, or because the expenditures fall within one of the exclusions from the credit.

Computer software development costs.-The Internal Revenue Service has taken the position that certain costs of developing computer software may be treated in a manner similar to costs incurred in product development which are subject to the section 174 deduction election (Rev. Proc. 69-21, 1969-2 C.B. 303). This treatment applies to costs incurred in developing new or significantly improved programs or routines that cause computers to perform desired tasks (as distinguished from other software costs where the operational feasibility of the program or routine is not seriously in doubt).

For purposes of the section 44F credit, otherwise qualifying types of expenditures (for example, direct wage expenditures) which are part of the costs of otherwise qualifying research for the development of new or significantly improved computer software are intended to be eligible for the credit to the extent that such expenditures (1) are treated as similar to costs, incurred in product research, which are deductible as research expenditures under section 174; (2) satisfy the requirements of new section 44F which apply to research expenditures; and (3) do not fall within any of the specific exclusions in new section 44F. That is, expenditures for developing new or significantly improved computer programs which otherwise would qualify for the section 44F credit are not to be disqualified solely because such costs are incurred in developing computer "software", rather than in developing "hardware".

Nonresearch expenditures.-The section 44F credit is not available for expenditures such as the costs of routine or ordinary testing or inspection of materials or products for quality control; of efficiency surveys or management studies; of consumer surveys (including market research), advertising, or promotions (including market testing or development activities); or of routine data collection. Also, costs incurred in connection with routine, periodic, or cosmetic alterations or improvements (such as seasonal design or style changes) to existing products, to production lines, or to other ongoing operations, or in connection with routine design of tools, jigs, molds, and dies, do not qualify as research expenditures under the credit.5


There are three express exclusions from the definition of qualified research for purposes of the section 44F credit.

First, expenditures for research which is conducted outside the United States do not enter into the credit computation.

4 Thus, the credit limitations and definitional restrictions (such as the distinctions between research and nonresearch expenditures, and between direct and indirect expenditures) which apply in the case of product research costs also apply in the case of the costs of developing new or significantly improved computer software.

The credit is not available for such expenditures as the costs of construction of copies of prototypes after construction and testing of the original model(s) have been completed; of preproduction planning and trial production runs; of engineering follow-through or troubleshooting during production; or of adaptation of an existing capability to a particular requirement or customer's need as part of a continuing commercial activity. For example, the costs of adapting existing computer software programs to specific customer needs or uses, as well as other modifications of previously developed programs, are not eligible for the credit.

Second, the credit is not available for research in the social sciences or humanities (including the arts), such as research on psychological or sociological topics or management feasibility studies. Third, the credit is not available for research to the extent funded by any grant, contract, or otherwise by another person (or any governmental entity).

In-house research expenditures

Employee wages qualify for the credit to the extent paid for engaging in the actual conduct of research, in the immediate supervision of the actual conduct of qualified research, or in the direct support of the actual conduct (or of the immediate supervision of the actual conduct) of qualified research. No amount of wages paid for overhead or for general and administrative services, or of indirect research wages, qualifies for the credit.

In addition, amounts paid for supplies used in the conduct of qualified research are eligible for the credit. The term "supplies" means any tangible property other than property of a character subject to the allowance for depreciation (cost recovery), land, or improvements to land. Neither the cost of acquisition of, nor the amount of depreciation (cost recovery) allowances with respect to, property which is of a character subject to the depreciation (cost recovery) allowance is eligible for the credit under present law, whether or not amounts of depreciation are deductible during the year under section 174.

Finally, amounts paid for the right to use personal property in the conduct of qualified research generally qualify for the credit, if such amounts are paid to a person other than the taxpayer or certain related persons.

Contract research expenditures

In addition to the three categories of in-house research expenditures, 65 percent of amounts paid by the taxpayer for qualified research performed on behalf of the taxpayer enters into the incremental credit computation. The research firm, university, or other person which conducts the research on behalf of the taxpayer cannot claim any amount of the credit for its expenditures in performing the contract.

If any contract research amount paid or incurred during a taxable year is attributable to qualified research to be conducted after the close of that taxable year, that amount is treated, pursuant to a prepayment limitation, as paid or incurred during the period during which the qualified research is actually conducted.6

• For example, if on December 1, 1983, a calendar-year taxpayer paid $100,000 to a research firm pursuant to a contract for qualified research to be performed on behalf of the taxpayer, and if the research firm conducts all of such qualified research during 1984, no amount is eligible for a credit for 1983, and $65,000 (65 percent of the total contract price) is treated as research expenditures of the taxpayer paid during 1984. Amounts which are treated as contract research expenditures during a particular taxable year pursuant to the prepayment limitation rule, and hence which count as expenditures for such year entering into the credit computation for such taxable year, also are treated as having been made during that same taxable year for purposes of determining average yearly base period expenditures in later year credit computations. Thus, in the example given above, $65,000 enters into the taxpayer's 1984 credit base.

Expenditures for university basic research

A special rule treats as qualified research expenditures 65 percent of certain corporate expenditures (including grants or charitable contributions) for basic research to be performed at a college, university, or other qualified organization pursuant to a written research agreement. Under this rule (described further below), a corporate taxpayer takes into account, for purposes of computing the incremental credit, 65 percent of qualifying basic research expenditures (subject to the contract research prepayment limitation).

Computation of allowable credit

General rule

As a general rule, the section 44F credit applies to the amount of qualified research expenditures for the current taxable year which exceeds the average of the yearly qualified research expenditures in the preceding three taxable years. The base period amount is not adjusted for inflation.

For the taxpayer's first taxable year to which the new credit applied (and which ended in 1981 or 1982), the credit applied to the amount of qualified research expenditures for that year which exceeded the amount of such expenditures in the preceding taxable year. Also, for the taxpayer's second taxable year to which the new credit applied (and which ended in 1982 or 1983), the credit applied to the amount of qualified research expenditures for that year which exceeded the average of yearly qualified research expenditures in the preceding two taxable years.7

New businesses

For a base period year during which it was not in existence, a new business is treated as having research expenditures of zero in such year, for purposes of computing average annual research expenditures during the base period. However, the taxpayer may be deemed to have expenditures in such a base period year pursuant to the 50-percent limitation rule (described below).

50-percent limitation rule

Base period research expenditures are treated as at least equal to 50 percent of qualified research expenditures for the current year. This 50-percent limitation applies both in the case of existing businesses and in the case of newly organized businesses.


Because the credit became effective for qualified research expenditures paid or incurred after June 30, 1981, a special rule was provided for computing base period expenditures for the taxpayer's taxable year which included July 1, 1981. A similar rule is to apply in the case of a taxpayer's first taxable year including December 31, 1985 (when the credit is scheduled to terminate).

8 For example, assume that a calendar-year taxpayer is organized on January 1, 1983; makes qualified research expenditures of $100,000 for 1983; and makes qualified research expenditures of $260,000 for 1984. The new-business rule provides that the taxpayer is deemed to have base period expenditures of zero for pre-1983 years. Without regard to the 50-percent limitation, the taxpayer's base period expenditures for purposes of determining any credit for 1984 would be the average of its expenditures for 1981 (deemed to be zero), 1982 (deemed to be zero), and 1983 ($100,000), or $33,333. However, by virtue of the 50-percent limitation, the taxpayer's average base period expenditures are deemed to be no less than 50 percent of its current year expenditures ($260,000), or $130,000. Accordingly, the amount of 1984 qualified research expenditures to which the credit applies is limited to $130,000, and the amount of the taxpayer's credit for 1984

Aggregation rules

To ensure that the section 44F credit will be allowed only for actual increases in research expenditures, special rules apply under which research expenditures of the taxpayer are aggregated with research expenditures of other persons for purposes of computing any allowable credit. These rules are intended to prevent artificial increases in research expenditures by shifting expenditures among commonly controlled or otherwise related persons. Changes in business ownership

Special rules apply for computing the credit where a business changes hands, under which qualified research expenditures for periods prior to the change of ownership generally are treated as transferred with the trade or business which gave rise to those expenditures. These rules are intended to facilitate an accurate computation of base period expenditures and the credit by attributing research expenditures to the appropriate taxpayer.

Limitations and carryover

General limitation

The amount of credit which may be used in a particular taxable year is limited to the taxpayer's income tax liability reduced by certain other nonrefundable credits.

Additional limitation on individuals

In the case of an individual who owns an interest in an unincorporated trade or business, who is a beneficiary of a trust or estate, who is a partner in a partnership, or who is a shareholder in an S corporation, the amount of credit that can be used in a particular year also cannot exceed an amount (separately computed with respect to the person's interest in the trade or business or entity) equal to the amount of tax attributable to that portion of the person's taxable income which is allocable or apportionable to such interest.9


If the amount of credit otherwise allowable exceeds the applicable limitation, the excess amount of credit can be carried back three years (including carrybacks to years before enactment of the credit) and carried forward 15 years, beginning with the earliest year.

For example, if in a particular year an individual partner derives no taxable income from a partnership which had made incremental qualified research expenditures, the individual may not use in that year any tax credit resulting from incremental qualified research expenditures of such partnership which otherwise would have been properly allowable to the partner (e.g., where the partnership had paid such research expenditures in carrying on a trade or business of the partnership and where any credit allowable to the partnership with respect to such expenditures had been properly allocated among the partners pursuant to Treasury regulations). If in this example the partner had derived taxable income allocable or apportionable to his or her partnership interest, then the amount of credit which may be used in that year by the individual partner may not exceed the lesser of the general limitation amount (described above) or the separately computed additional limitation amount applicable to individuals.

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