Final Regulations R & D expenditures, treatment of material costs
The Treasury Department and IRS today released for publication in the Federal Register final regulations (T.D. 9680) that amend the definition of “research and experimental expenditures” under section 174 and that provide guidance on the treatment of amounts paid or incurred in connection with the development of tangible property, including pilot models.
Taxpayers may apply the final regulations to tax years for which the limitations period for the assessment of tax has not expired. [Taxpayers had earlier been assured that the IRS would not challenge return positions consistent with the proposed regulations in tax years prior to the publication of final regulations.]
Over the years, there have been questions concerning the application of the regulations and the “Depreciable Property Rule”—i.e., that amounts expended for R&D do not include the costs of the component materials of depreciable property, the costs of labor, or other elements involved in its construction and installation, or costs attributable to the acquisition or improvement of the property—to costs incurred by taxpayers in the development of tangible property.
In numerous examinations, the qualification of material costs used in developing such property has been an issue.
In an attempt to provide taxpayers with further guidance and clarity on these issues, proposed regulations were issued in September 2013 to make the following changes to the current section 174 regulations:
- First, to clarify that the ultimate success, failure, sale, or other use of the research or property resulting from the R&D activity is not relevant to a determination of eligibility under section 174—thus, the fact that the taxpayer sells a piece of property that includes materials that were characterized as R&D expenses when they were used, or that the taxpayer begins to use the completed property in its trade or business, will not per se disqualify those R&D expenses.
- Second, to clarify that the Depreciable Property Rule is an application of the general definition of R&D expenditures under the current regulations and is not to be applied to exclude otherwise eligible expenditures. Amounts for materials and supplies used in the research process—to eliminate uncertainty concerning the development or improvement of a product—will be R&D expenditures even if the product itself ultimately is a depreciable asset.
- Third, to define the term “pilot model”—i.e., any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product. The term “pilot model” includes: (1) a fully functional representation or model of the product; or (2) a component of a product (to the extent the “shrinking-back” provision, described below, applies).
- Fourth, to provide 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 R&D.
- Fifth, to provide a “shrinking-back” provision—similar to a rule in the research credit regulations—to recognize situations in which the costs of a component part of a larger product can qualify as R&D expense, even though the development of the overall product has passed the point at which uncertainties have been resolved.
The proposed regulations also included examples to illustrate, among other things: (1) that material and labor costs of a component can be R&D expense even though the rest of the property is functional; and (2) that all material and labor costs of a product being developed and eventually sold can qualify as R&D expense, if the uncertainties about development apply throughout the product; the pilot model itself can be sold without disqualifying any of the R&D expense.
Comments on the proposed regulations were made in writing and at a hearing, but the IRS and Treasury decided that only a few changes would be made in finalizing these regulations. Many of the comments are addressed in the preamble to the final regulations, as summarized below.
- Uncertainty – Some commentators requested a more specific definition of when “uncertainty” is resolved, as the proposed regulations made “the elimination of uncertainty” the point at which material and supply costs will no longer be R&D expenditures. The preamble to the final regulations explains that the current regulations already provide that uncertainty is eliminated when there is information available to the taxpayer establishing the capability or method for developing or improving the product or the appropriate design of the product, and that this determination is based on the taxpayer’s facts and circumstances. Thus, the final regulations do not provide additional guidance with respect to the definition of “uncertainty” or a “bright-line standard,” as requested by some commentators.
Further, some commentators requested that the regulations explicitly incorporate a rule that is stated in the regulations defining qualified research for purposes of the research credit—that 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 Treasury noted in the preamble that neither the section 174 statute nor its legislative history suggests that, to qualify under section 174, a taxpayer must be seeking information that would satisfy such a high standard; thus, they declined to adopt the requested comment.
- Supplies – Some commentators requested that the final regulations include a clarification that indirect or ancillary supplies used in research are eligible under section 174 although ineligible under section 41. However, as explained by the preamble, the IRS and Treasury believe that the current regulations are sufficiently broad to include indirect or ancillary supplies for section 174, if they meet the requirement that they be used in resolving uncertainty. The final regulations, therefore, do not adopt these suggestions.
- Pilot model – Today’s final regulations modify Example 5 to clarify that when a taxpayer develops multiple pilot models in the process of experimentation, it is not necessary for each pilot model to be tested for a discrete purpose for the cost to qualify as research and experimental expenditures under section 174. Other comments concerning the pilot model issue were not adopted.
- Shrinking-back rule – Several commentators argued that the shrinking-back rule could be applied to exclude from section 174 the cost of testing to eliminate uncertainty regarding the integration of an experimental component with a non-experimental product. The preamble states that the IRS and Treasury believe that the current regulations are sufficiently broad to include such costs relating to integration of a component even when the requirements for R&D expenditure treatment are not met for the product as a whole. However, in response to other concerns, and to avoid confusion between the section 174 requirements and the requirements of the shrinking-back rule under the section 41 regulations, the final regulations drop the term “shrinking back rule” and eliminate references to section 41. Also, Example 8 is modified and an additional Example 9 is added to demonstrate how section 174 can apply to integrating new components into a product or making improvements to the components of an existing product. Example 9 makes clear, furthermore, that improvements to components in an existing product can be considered research and development in a new product.
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