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Under present law, the section 44F credit applies to qualified research expenditures paid or incurred after June 30, 1981 and before January 1, 1986.
Explanation of Title I of the Bill
Extension of incremental credit
Section 101 of the bill would make permanent the section 44F credit for increased research expenditures.
Modification of definition of qualified research
Present law defines qualified research for purposes of the section 44F credit principally by a cross-reference to the definition of research developed in Treasury regulations under section 174, which allows a current deduction for certain "research or experimental expenditures" (as described above). The bill would instead provide a separate, statutory definition of qualified research for purposes of the credit, effective for post-1983 taxable years. This definition would not affect the category of research expenditures qualifying for the section 174 deduction.
Under the bill, qualified research would be defined to mean either
(A) a planned search or critical investigation (including basic research) undertaken for the purpose of discovering information which may be potentially useful in the development of a new or significantly improved business item of the taxpayer, or (B) applying the results obtained from such research activity, or other knowledge, to develop a new or significantly improved business item of the taxpayer. The definition would include as research the conceptual formulation, design, testing, and reformulation of possible business item alternatives and the design, construction, and testing of prototypes, models, and pilot plants.
Business item definitions
The bill would generally define the term "business item" to mean a product (whether or not constituting tangible personal property), process, technique, formula, invention, or a significant component part or element of a product or process, for sale, lease, license, or use by the taxpayer in a trade or business. Under a special rule in the bill, computer software that is separately developed by the taxpayer solely for its own internal use would qualify as a business item (and hence the development costs of such software would be eligible for the credit) only if the software is used in (1) qualified research undertaken by the taxpayer, (2) a production process, or (3) the performance for customers of services of which such software together with the corresponding hardware is the predominant component, or if not so used, only to the extent allowed by Treasury regulations.
A business item which the taxpayer seeks to develop or improve would be treated under the bill as new or significantly improved if both (1) the business item is developed by means of the process of experimentation, including testing in search for or evaluation of alternatives, and also (2) the predominant portion of the new characteristics or improvement relates to such factors as function, performance, reliability, quality, or cost, rather than to style, taste, cosmetic, or seasonal design factors. After a new or significantly improved business item has been fully developed to the point where it both constitutes a finished business item which meets the specific functional and economic requirements of the taxpayer for that item and also is ready for commercial sale or use, then no further expenditures with respect to that item would be eligible for the credit.
The bill would exclude from the definition of qualified research any development of plant processes, machinery, or techniques for commercial production of a new or significantly improved business item, except where such process, machinery, or technique itself constitutes a new or significantly improved business item. The adaptation of an existing business item to a particular requirement or customer's need as part of a continuing commercial activity, unless such adaptation will result in a new or significantly improved business item, would not qualify as research.
As in the case of present law, the bill would exclude from eligibility for the credit expenditures for research (1) which is conducted outside the United States; (2) in the social sciences, arts, or humanities; or (3) to the extent funded by any grant, contract, or otherwise by any person (or any governmental entity). Also as under present law, the credit would not be available for the costs of efficiency surveys, management studies, market research, market testing and development (such as advertising or promotions), routine data collections, or routine or ordinary testing or inspection of materials or business items for quality control, or for the costs of ascertaining the existence, location, extent, or quality of any deposit of ore or other mineral (including oil and gas).10
The modifications to the definition of credit-eligible research expenditures made by section 102 of the bill would apply to taxable years beginning after 1983.
Treatment of equipment depreciation for credit, ACRS purposes
Credit extended to depreciation
Under present law, 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, whether or not amounts of depreciation are deductible during the year under section 174. Under section 103(a) of the bill, the amount of depreci
10 See note 3, supra.
ation or cost recovery allowances (under secs. 167 or 168) in respect of tangible personal property used in the conduct of qualified research would be qualified research expenditures, i.e., would enter into the incremental credit computation.
The amendment made by this provision would be effective, for purposes both of computing the credit and also of computing base period research expenses, for taxable years beginning after 1983.
Change in ACRS treatment
Under ACRS as enacted in ERTA, personal property used in connection with research and experimentation is classified as threeyear recovery property (sec. 168(c)(2)(A)). The regular investment tax credit for property in the three-year class is six percent.
Section 103(b) of the bill would remove research equipment from the three-year class. Accordingly, research equipment would constitute five-year recovery property and would be eligible for a ten-percent investment tax credit.
The amendment made by this provision would apply to property placed in service in taxable years beginning after 1983.
Increase in qualifying percentage of contract research expenditures
The bill would increase, from 65 percent to 75 percent, the percentage of a taxpayer's contract research expenditures which enter into the computation of the section 44F credit. This provision would be effective, for purposes both of computing the credit and also of computing base period research expenses, for taxable years beginning after 1983.
Availability of credit to start-up corporations, partnerships, and other joint ventures
Under section 104 of the bill, all otherwise qualifying in-house and contract research expenses paid or incurred by a corporation1 would be treated as qualified research expenses for credit purposes without regard to the trade or business test of present law. Thus, the research expenditures of a start-up corporation whose activities have not yet reached the level of constituting a trade or business (as defined for purposes of sec. 162) would be eligible for the credit. Also, the bill would make the credit available for corporate expenditures for research endeavors that are not directly related to any of the corporation's existing trades or businesses.
With respect to in-house and contract research expenses paid or incurred by a partnership, the bill would provide that, as a general rule, the trade or business test is to be applied at the partnership level without regard to the trade or business of any partner. If at the partnership level the test is met, any available credit would be apportioned among the partners in accordance with the partnership allocation rules of the Code (sec. 704). Under these rules, the allocation of partnership credits, like the allocation of partnership overall income and loss and items of income, loss, and deduction, is generally determined by the partnership agreement if the alloca
11 For this purpose, the term corporation would not include S corporations (sec. 1361(a)), personal holding companies (sec. 542), or service organizations (sec. 414(m)(3)).
tion has substantial economic effect; if not, the allocation is made in accordance with the partners' interests determined by taking into account all facts and circumstances.
Under the bill, a partnership could elect in two cases to treat an in-house or contract research expense it has paid or incurred other than in carrying on a trade or business of the partnership as a qualified research expense. First, a partnership could so elect if each partner is a corporation;12 thus, the bill would allow corporate joint venturers to treat in-house and contract research expenses paid or incurred by the partnership as qualified research expenses without regard to the trade or business requirement. Second, a partnership (all of whose partners are not regular corporations) could so elect if all of the in-house or contract research expenses paid or incurred by the partnership would have satisfied the trade or business requirement as applied to each of the partners had each of the partners directly conducted the research. In either of these two cases, the qualified research expense would be treated as paid or incurred directly by the partners and would be apportioned among the partners in accordance with the Code partnership allocation rules described above.
The amendments made by this provision would be effective for taxable years beginning after 1983.
12 See note 11, supra.
b. Increased credit for corporate support of basic research at universities
Under present law, a corporation 13 may take into account, for purposes of computing the section 44F credit for a taxable year, 65 percent of qualifying basic research expenditures for that year (subject to the contract research prepayment limitation).14 Similarly, this percentage is treated as research expenditures in a base period year when calculating the credit in subsequent years.
The special rule for basic research applies only to expenditures paid or incurred pursuant to a written research agreement between the taxpayer corporation and a college or university, certain tax-exempt scientific research organizations, and certain qualified funds (organized exclusively to make basic research grants to colleges and universities).
For purposes of this special rule, the term "basic research" means any original investigation for the advancement of scientific knowledge not having a specific commercial objective. However, the term basic research does not include expenditures for any activity excluded from the section 44F definition of qualified research, e.g., expenditures for basic research in the social sciences or humanities (including the arts).
Illustration of computation
Assume that a corporation makes qualified in-house research expenditures_totalling $120 million in each of the years 1980, 1981, and 1982. In addition, in 1981 the corporation makes a $6 million grant to a university for qualifying basic research; all of this amount is expended by the university in that year. In 1983, the corporation makes qualified in-house research expenditures totalling $130 million and also contributes $3 million to a university for basic research pursuant to a written research agreement. The university expends 50 percent of the 1983 contribution funds during 1983 and the rest during 1984.
Under these facts, the corporation's qualified research expenditures for 1983 would equal $130 million plus 65 percent of $1.5 million ($975,000). The corporation's base period expenditures with respect to 1983 would be the average of its qualified research expenditures for 1980, 1981, and 1982, or $121,300,000. Accordingly, the 25percent credit for 1983 would apply to the excess of total current
13 See note 11, supra.
14 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 as paid or incurred in the year or years during which the qualified research is actually conducted. See note 6, supra.