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curred 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;2 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.3

Exclusions

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.

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).

2 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.

3 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.

Qualified in-house expenditures

Employee wages qualify for the credit if 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. Finally, amounts paid for the right to use personal property in the conduct of qualified research generally qualify for the credit.

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 as paid or incurred during the period during which the qualified research is actually conducted.

Expenditures for certain 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, 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. However, 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.*

New businesses.-If the taxpayer was not in existence during a base period year, then the taxpayer is treated as having research expenditures of zero in such year, for purposes of computing average annual research expenditures during the base period, subject to the 50-percent limitation rule.

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.5 This 50-percent limitation applies both in the case of existing businesses and in the case of newly organized businesses.

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 per

sons.

Business ownership rules.-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 a subchapter 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

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).

5 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 qualifying for the credit is limited to $130,000, and the amount of the taxpayer's credit for 1984

amount of tax attributable to that portion of the person's taxable income which is allocable or apportionable to such interest.

Carryover.-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.

Effective date

Under present law, the section 44F credit applies to qualified research expenditures paid or incurred after June 30, 1981 and before January 1, 1986.

General rule

Explanation of the Bill (S. 738)

The bill would make permanent the section 44F credit for increased research expenditures.

Effective date

The provisions of the bill would be effective on enactment.

3. S. 1147-Senators Danforth, Tsongas, Symms, and Thurmond

In general

"Mortgage Debt Forgiveness Tax Act of 1983"

Present Law

Under present law, income is realized when indebtedness is forgiven or in other ways cancelled (Code sec. 61(a)(12)). For example, if a corporation has issued a $1,000 bond at par which it later repurchases for only $900, thereby increasing its net worth by $100, the corporation realizes $100 of income in the year of repurchase (U.S. v. Kirby Lumber Co., 284 U.S. 1 (1931)).

Discharge of qualified business indebtedness

Present law provides an exclusion, at the taxpayer's election, of income from discharge of qualified business indebtedness (secs. 108(a)(1)(C), 1017). The latter term means indebtedness incurred or assumed (1) by a corporation or (2) by an individual in connection with property used in the individual's trade or business.

The amount so excluded must be applied to reduce the taxpayer's basis (but not below zero) in depreciable property or, at the taxpayer's election, in real property held by the taxpayer for sale to customers in the ordinary course of business. If the taxpayer disposes of property.the basis of which has been reduced under these rules, the amount of the reduction is subject to recapture at ordinary income rates.

Discharge in bankruptcy or insolvency

Present law also provides an exclusion for income from a discharge of indebtedness occurring in a bankruptcy proceeding or when a taxpayer is insolvent (secs. 108(a)(1)(A) and (B), 1017).

The amount so excluded must be applied to reduce certain tax attributes of the taxpayer, including (in the order in which reduction is to occur) net operating losses and carryovers, carryovers of investment tax credit and certain other credits, capital losses and carryovers, basis of the taxpayer's assets (including depreciable and nondepreciable assets), and foreign tax credit carryovers. The basis of the taxpayer's assets may not be reduced below the amount of the taxpayer's remaining undischarged liabilities. Alternatively, the taxpayer may elect to apply the excluded amount first to reduce basis in depreciable property (or in real property held for sale to customers in the ordinary course of business). If the taxpayer disposes of property the basis of which has been reduced under these rules, the amount of the reduction is subject to recapture at ordinary income rates.

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